Business Cycles

Mr. X and his daughter, Ms. X, are long-time BCA clients who visit our office toward the end of each year to discuss the economic and financial market outlook for the year ahead. This report is an edited transcript of our recent conversation. Mr. X: I have been eagerly looking forward to this meeting given my many concerns about the outlook. Our portfolio has done well in the past year thanks to the surge in bond prices and the outperformance of defensive equities. However, I am deeply troubled by the amount of monetary stimulus required to support risk assets, and by how expensive bonds and equities are. Moreover, the global economy remains engulfed in deflationary risks, and policymakers are running out of ammunition. As always, there is much to talk about. Ms. X: Let me add that I am also pleased to once again be here to discuss the major risks and opportunities in the global marketplace. A year ago, I held a more positive market view than my father. Directly after our meeting, the deep market correction gave me second thoughts, but ultimately, the rebound in stock prices vindicated my view. Clearly, your assertion that markets would be turbulent proved correct. Since I joined the family firm in early 2017, I have been pushing my father to keep a higher equity exposure than he was normally comfortable with. We agreed to still favor stocks last year, albeit, with a bias toward defensive sectors, and this strategy paid off. But after the past year’s powerful rally in both bonds and stocks, we are again left wondering how to position our portfolio. Ultimately, I do not believe a recession is imminent. Yes, stocks are expensive, but bonds are even more so. Since I expect economic growth to pick up, I am inclined to tilt the portfolio further into equities and move away from our preference for defensive sectors. As usual, I am very interested to hear your views. BCA: Our core theme for 2019 was that we would face classic late-cycle turbulence. Despite this volatility, a run-up in asset prices was likely. Soon after we met, the stock market plunged, hitting a low on December 26, 2018. We anticipated the Federal Reserve to be much more hawkish than what actually transpired. Wage growth and even core inflation have remained firm in the US, but the weakness in global inflation expectations drove central banks’ reaction functions more powerfully than we anticipated. Moreover, the rapid escalation of the Sino-US trade war added a layer of uncertainty that exacerbated the economic slowdown that had started in mid-2018, forcing global central banks to ease policy as an indemnity against recession. Looking ahead, central bankers are highly unlikely to tighten monetary policy as long as inflation expectations remain below their normal range consistent with a 2% inflation target. We agree that the odds of a US recession in the coming year are still low because financial conditions are set to remain accommodative, Chinese authorities are setting policy to shore up growth, and a trade truce is likely. Global economic activity will rebound in early 2020. Instead, the most probable timeframe for a broad based recession is late 2021/early 2022. As a result, we remain positive on risk assets, especially foreign stocks. We are also underweighting bonds as they offer extremely poor absolute and relative value. Mr. X: I can see we will have a lively discussion because I do not share your or my daughter’s optimism. My list of concerns is long, I hope we have time to get through them all. But first, let’s briefly review your predictions from last year. BCA: This exercise is always interesting and often humbling, too. A year ago, our key conclusions were that: Tensions between policy and markets would be an ongoing theme in 2019. With the US unemployment rate at a 48-year low, it would take a significant slowdown for the Fed to stop hiking rates. Ultimately, the Fed would deliver more hikes in 2019 than discounted in the markets. This would push up the dollar and keep the upward trend in Treasury yields intact. The dollar would peak in mid-2019. China would also become more aggressive in stimulating its economy, which would boost global growth. However, until both of these things happened, emerging markets would remain under pressure. We favored developed market equities over their EM peers. We also preferred defensive equity sectors such as healthcare and consumer staples over cyclical sectors such as industrials and materials. Within the developed market universe, the US would outperform Europe and Japan over the next few quarters, especially in dollar terms. Stabilization in global growth would ignite a blow off rally in global equities. If the Fed was raising rates in response to falling unemployment, it would be unlikely to derail the stock market. However, once supply-side constraints began to bite fully in early 2020 and inflation began to rise well above the Fed’s target of 2%, stocks would begin to buckle. This would mean that a window would exist in 2019 for stocks to outperform bonds. We would maintain a benchmark allocation to stocks, but increase exposure if global bourses were to fall significantly from then (late 2018) current levels without a corresponding deterioration in the economic outlook. Corporate credit would underperform stocks as government bond yields rise. A major increase in credit spreads was unlikely as long as the economy remained in expansion mode, but spreads could still widen modestly. US shale companies had been the marginal producers in the global oil sector. With breakeven costs in shale close to $50/bbl, crude prices would be unlikely to rise much from current levels over the long term. However, we expected production cuts in Saudi Arabia would push prices up, with Brent crude averaging around $82/bbl in 2019. A balanced portfolio was likely to generate average returns of only 2.8% a year in real terms over the next decade. This compares to average returns of around 6.6% a year between 1982 and 2018. As already noted, our forecast for more Fed rate hikes was wrong. This meant that we were offside in our duration call. Ultimately, 10-year Treasuries have generated returns of 10.8% so far this year, and German bunds and Japanese government bonds returns of 5.8% and 1.0% in EUR and JPY terms, or 2.5% and 2.0% in USD terms, respectively (Table 1). Nonetheless, our expectation of a run-up in risk asset prices was spot on. Equities outperformed bonds, with global stocks climbing 22.2% in USD terms. We missed the initial outperformance of corporate bonds relative to Treasuries, as investment grade credit rose by 13.9%. However, our bond team took a more constructive stance on corporates as the year progressed. Table 1Market Performance Chart 12019 Was A Good Year For Stocks In terms of regional allocation recommendations, we were correct to overweight US equities which beat non-US stocks by 13.4%, partly thanks to the dollar’s appreciation. We were also right to underweight EM equities, with Asia and Latin America generating dollar returns of only 12.6% and 6.9%. Overall, it was a good year for financial markets (Chart 1). Our growth forecasts were mixed. We predicted global growth would slow in the first half of 2019 but improve thereafter. Instead, the slowdown extended and intensified into the second half of the year as the Sino-US trade war escalated more than expected, and Chinese policymakers were more reluctant to reflate than anticipated. The IMF also revised down its growth forecasts. In the October 2019 World Economic Outlook report, growth in advanced economies for the year was cut to 1.7% from 2.1% compared to 2018 forecasts, led by a downward revision to 1.5% from 2% in Europe (Table 2). They also pared down 2019 EM growth estimates to 3.9% from 4.7%. Consequently, inflation was softer than originally predicted. These trends in economic activity meant that our dollar call was partially right. The currency did not peak in the middle of the year as we foresaw, but has been flat since the spring and today trades where it was in April. Meanwhile, the weaker-than-expected growth put our oil call offside, with Brent averaging $62/bbl this year, not $82/bbl. Table 2IMF Economic Forecasts The Cycle’s End Game Mr. X: You mentioned that you remain positive on risk assets and stocks for 2020. You will not be surprised that I am extremely skeptical of this view. The Fed could only raise rates to 2.5% before all hell broke loose, and it has now cut them back to 1.75%. The European Central Bank has lowered its deposit rate to -0.5% and is resuming its asset purchase program, while the Bank of Japan is clearly out of ammunition. Yet global growth remains weak. Despite this lack of economic traction, US stocks are at a record high and are unequivocally expensive. This situation seems untenable. If global growth weakens further, there is little more policymakers can do. I think the risk of a recession is a lot more elevated than you believe, especially as we cannot count on a lasting trade détente. Meanwhile, the US presidential election makes me uncomfortable, and I cannot see how business leaders will want to deploy capital to expand capacity given the risk that the regulatory and tax environment could become hostile to the corporate sector. If I’m wrong about growth – and I hope I am – then inflationary pressures will build and central banks will have to tighten policy suddenly. As bond yields rise, stocks will be sold and yet bonds will not offer any protection since they yield so little. Also, I have not even talked about negative interest rates. $12.1 trillion of debt yields less than zero percent. This is obviously preventing creative destruction from purging the system of rot. It is also promoting capital misallocation and undue risk-taking by financial institutions who cannot meet fiduciary liabilities. Ms. X: Based on this tirade, you can easily imagine what life at the office has been like in recent months. I do share some of my father’s concerns. Negative rates cannot be a good thing, especially from a long-term perspective. If growth weakens further, I’m also concerned that central banks have few options left. However, I do not see these risks as imminent. There are nascent signs that the global economy will stabilize soon; both President Trump and President Xi have strong incentives to reach a trade truce; and central banks are nowhere near removing the proverbial punch bowl. While US stocks are expensive, other risk assets offer value if global growth rebounds. The wall of worry is high, but stocks can and will climb that wall. BCA: Your debate is similar to our own internal discussions. It is undeniable that the investing landscape looks shaky at the moment, especially with the S&P 500 currently trading at 18-times forward earnings. However, the situation you are describing is a direct consequence of one BCA’s long running macro themes: The end of the debt supercycle. While the debt supercycle is dead in advanced economies, it remains very much alive in emerging markets, and China in particular. The private debt load in advanced economies has declined by 20% of GDP since 2009 (Chart 2A). Despite the burgeoning US federal government deficit, public debt accumulation has not been strong enough to cause total debt loads to increase. Instead, aggregate indebtedness has been stuck slightly above 260% of GDP for the past 10 years. Depressed, and in some cases, negative interest rates reflect weak demand for credit. Chart 2AThe Debt Supercycle Is Dead In DM... Chart 2B...But Not In EM   The end of the debt supercycle has both a negative and positive impact. Without increasing leverage, domestic demand cannot grow faster than trend GDP. Thus, it takes much more time for inflationary pressures to build. Concurrently, in the absence of inflationary pressure, more time passes before monetary policy reaches a restrictive level causing recession. The upshot is that the business cycle can last much longer. Moreover, a world less geared to credit accumulation reduces the fragility of the financial system, at the margin. While the debt supercycle is dead in advanced economies, it remains very much alive in emerging markets, and China in particular (Chart 2B), where the demand for credit is still very sensitive to changes in monetary settings. EM countries are the major source of volatility in the global business cycle. Chinese policymakers’ management of the tradeoff between growth and leverage will determine whether the global economy can avoid deflation. If they decide to tackle debt excesses head on, EM credit growth will contract and EM final demand will suffer. In this scenario, negative rates will persist in low-growth advanced economies, and the Fed will be incapable of raising rates because global deflationary forces will be too strong. Chart 3The World Is In The Midst Of A Deflationary Episode The second half of 2018 and the whole of 2019 gave us a taste of these forces. When China tightened credit conditions, the EM economies slowed first. Trade and manufacturing hubs like Europe, Australia and Japan quickly followed. A deflationary wave spread around the world, as evidenced by a drop in global producer prices (Chart 3). The US is a comparatively closed economy, but it could not avoid this gravitational pull. The ISM manufacturing survey ultimately started to contract in August 2018, converging to weakness in the rest of the world. The trade war’s hit to business confidence added insult to the injury of an already weak economic environment. Looking ahead, our optimism reflects an expectation that Chinese policymakers will adopt a more pro-growth policy stance because they too are spooked by the downtrend in their economy. While the Politburo Standing Committee has not abandoned its structural reform agenda, it realizes that aggressive deleveraging is dangerous. The Chinese economy is growing at its weakest pace in nearly 30 years and deflation is once again taking hold. In response to date, policymakers have lowered China’s reserve requirement ratio by 400 basis points, cut taxes by 2.8% of GDP, increased the issuance of local government bonds to finance public infrastructure projects, and boosted capex at state-owned enterprises. EM economies will respond to these stimulative measures. The Chinese credit and fiscal impulse has stabilized (Chart 4). Meanwhile, the Fed has pushed the real fed funds rate 74.4 basis points below the Holston-Laubach-Williams estimate of the neutral rate, and coordinated global policy easing points to a rebound in the global manufacturing sector (Chart 4, bottom panel). Moreover, the global inventory purge that magnified the industrial sector’s pain is getting exhausted and the auto sector is looking up. Finally, we agree with Ms. X that both President Trump and President Xi have their own incentives to deescalate trade policy uncertainty. We are entering the end game of this business cycle and bull market. Global borrowing rates will rise, but only to a limited extent. Rightly or wrongly, major central banks are terrified by the prospect of the Japanification of their economies. Practically speaking, this means that they want inflation expectations to move back up to normal levels (Chart 5). However, after undershooting their 2% targets for 11 years, achieving this objective will require central banks to let realized inflation overshoot these targets first. Thus, central banks are unlikely to tighten policy until late next year at the earliest, which will limit how far yields can climb in 2020. Chart 4…But Do Not Bet Against Reflation Chart 5Depressed Inflation Expectations   Equities and other risk assets should perform well if global growth re-accelerates but interest rates don’t rise much at first. Some benefit of this fertile backdrop is already priced in, but many pockets of value levered to stronger global growth still exist. We are entering the end game of this already long business cycle. While the general environment favors remaining invested in risk assets in 2020, this is likely the last window of opportunity to do so. Today’s accommodative monetary policy will revive inflationary pressures in 2021, and central banks will ultimately be forced to lift rates much more aggressively. China will continue to resist excessive leverage. Neither the business cycle nor the equity bull market will withstand these final assaults. Mr. X: Your benign outlook reminds me of when we met in December 2007. Do you remember? You told me that the housing slowdown and the credit market seizure were large risks, but central banks would put a floor under global growth. How did that turn out? I agree that in advanced economies, overall debt loads have been stable. But this belies major disparities. For example, US corporate debt has never represented a larger share of GDP than it does today. This must be a major vulnerability. While household balance sheets look healthy, I do not think consumption will save the day if companies are cutting capex and employment while they clean up their balance sheets. Countries like Canada and Australia are drowning in private sector debt. How can you ignore these vulnerabilities? BCA: A comparison with 2008 actually reveals why advanced economies, particularly the US, are not the powder keg that they once were. US corporate debt is elevated when compared to GDP, but profits also represent a much larger share of GDP than they did 10 or 20 years ago, and interest rates are close to historic lows. As a result, interest coverage ratios are still adequate (Chart 6). In 2007, household debt loads were large, but interest payments also accounted for 18.1% of disposable income, the highest proportion since 1972. Additionally, US firms’ debt-to-asset ratio is in line with the post-1970 average of 22.1%. Finally, US businesses have not used rising leverage to fund capital spending, as demonstrated by the elevated age of the capital stock. Thus, the US corporate sector continues to generate positive net savings. Ahead of recessions, US businesses typically generate negative net savings. The composition of the creditors is another important difference. In 2007, an extremely large share of the spurious borrowings resided on banks’ balance sheets. Moreover, the banking system was woefully undercapitalized with a leverage ratio of 17x. Weak banks had to absorb 2.2 trillion of losses after 2008. Consequently, the money creation mechanism broke down, and money multipliers collapsed (Chart 7). Today, US banks boast relatively stronger balance sheets, and they are still judicious about extending credit despite being less exposed to the corporate sector than they were to the mortgage market in 2008. Instead, most corporate debt is held by less levered entities such as ETFs, pension plans, and insurance companies. The leveraged losses that proved so debilitating in 2008 are less likely to be a source of systemic risk in this cycle. Chart 6US Businesses Can Still Service Their Debt Chart 72008 Heralded A Destruction Of Money   Countries like Australia and Canada have much more worrisome private sector debt dynamics, as their servicing costs are elevated (Chart 8). However, these economies are unlikely to collapse when global rates are low, as long as the global economy can avoid a recession, which would reduce export revenue in these trade-sensitive countries. You expect a moderate rebound in global growth next year, but not a sharp acceleration because Chinese stimulus will not be that aggressive. The bottom line is that both the US corporate sector and at-risk countries like Canada should avoid a day of reckoning until interest rates rise meaningfully. As we have already mentioned, central banks are very clear that they will allow inflation to overshoot before tightening policy anew. We monitor US inflation breakeven rates to gauge the likely timing of that outcome. At 1.6%, they remain well below the 2.3% to 2.5% range, which is historically consistent with central banks durably achieving their inflation target (Chart 9). Until inflation expectations are re-anchored back up in that range, we will not worry about an imminent tightening in monetary conditions. Chart 8Canada And Australia Are Close To Their Debt Walls Chart 9The Fed Is In No Rush To Tighten   Chart 10Inflation Is A Lagging Indicator It is true that inflationary pressures are building in the US. Historical evidence points to a kink in the Phillips curve, the link between wage growth and the unemployment rate. Since the labor market is tight, we are already seeing average hourly earnings growth accelerate. Moreover, the output gap is mostly closed. However, keep in mind that inflation is also a lagging economic indicator (Chart 10). Consequently, the recent global economic slowdown is likely to keep US inflation at bay for most of 2020. The sharp fall in US capacity utilization along with the decline in imported goods and core producer price inflation corroborate this picture. Mr. X: So you believe that as long as rates stay low, the day of reckoning will be delayed. But ultimately, that it is unavoidable. BCA: Correct. No matter what, we are entering the end game of this already long business cycle. The current period of easy policy will allow cyclical spending to rise as a share of output, and debt to build up again over the coming 18 months. Because slack is clearly limited, this latest wave of policy easing will generate inflationary pressures. Ultimately, the Fed will be forced to play catch up and tighten more aggressively than expected in 2021. Paradoxically, the longer the onset of recession is delayed, the deeper it is likely to be… Mr. X: Because imbalances and vulnerabilities will only grow larger! BCA: Absolutely! Mr. X: That is something we can agree on. Ms. X: The way you complete one another’s sentences is a testament to how many years you have been talking to each other. For me, the most concerning issue is political risk. While I am more positive on the outlook for trade policy than my father, I do worry about the impact of US election risk on capital spending. Chart 11If The 2012 Election Is Any Guide, Trump Can Still Win A Second Term BCA: On the trade war, we would like to address your father’s concerns. All politicians, even unconventional ones like President Trump, seek re-election. Yet, President Trump’s overall approval rating is low (Chart 11). If the election were held today, his odds of winning would be minimal. However, US presidential elections do ultimately favor the incumbent. If the re-election of President Obama in 2012 is any guide, President Trump has enough time to boost his approval rating over the coming 12 months to secure a second term through the Electoral College. In order to achieve this outcome, he must reverse the large slowdown in wage growth currently plaguing the swing states he won by only a small margin in 2016 (Chart 12). Workers in states like Michigan, Pennsylvania and Wisconsin are suffering disproportionately from the uncertainty created by the trade tensions. President Trump will have to pause the tariffs – and even cut tariff rates – to support the economy and reassure voters. Chart 12Trump's Fear Is Coming True China is willing to accept a trade truce. The Chinese economy is weak and producer prices are once again deflating. President Xi doesn’t want to preside over another massive surge in leverage or a 1930’s Irving Fisher-style deflationary spiral. Reviving private sector investment sentiment via a reduction in trade policy uncertainty would help stabilize spending and avoid a disorderly economic slump. Moreover, President Xi may not trust the current White House, but the prospect of a Democratic administration that will be tough on both environmental standards and human rights would offer little solace. This brings us to the US election. The recent Bank of America Merrill Lynch positioning survey shows that the investment community shares your concerns. This risk is hard to quantify. The Democratic nomination is wide open. Former Vice President Joe Biden leads the opinion polls, and is a known quantity. Meanwhile, the rising progressive wing of the party, embodied in Senator Elizabeth Warren, is hostile to business and likely to cause concerns in boardrooms across the US, especially in the tech, energy, financial services and healthcare sectors. This could dampen animal spirits. Biden’s and Warren’s odds of beating President Trump are overstated by current polls, especially if the President softens his stance on trade to allow for a growth pick-up. Moreover, to be competitive nationally, Senator Warren will have to abandon some of her more progressive plans and pivot toward the center. The recent upbeat equity market performance of sectors like managed healthcare suggests that markets are discounting this shift. Thus, we doubt the election is currently really weighing on business intentions. The recent pick up in capital spending intentions in various Fed Manufacturing surveys fades this risk. Chart 13A Structural Tailwind Has Vanished What is clear though is that if the economy were to weaken further, Senator Warren’s chances would improve and CEOs would genuinely begin to worry about re-regulation, potentially unleashing a vicious cycle. Thus, the end game is an unstable equilibrium. On a structural basis, whether one looks at the rise of populism or the geopolitical rivalry between China and the US, trade tensions will remain a pesky feature of the global economy. In effect, the trade truce will not be a permanent deal. The global economy has therefore lost the tailwind of deepening global integration achieved through trade (Chart 13). This will limit global potential GDP growth. Ms. X: Thank you. I think the time is right to explore your economic outlook in more detail. The Economic Outlook Chart 14China: Modest Reflation Is Underway Mr. X: From your arguments, it seems that the outlook for China and Emerging Markets is critical, so let’s start there. My impression is that President Xi is not abandoning his structural reform agenda. Avoiding the middle-income trap will require decreasing China’s dependence on credit as a growth driver. Can economic activity really stabilize under those circumstances? BCA: You are correct: Senior Chinese administrators are reluctant to allow another major phase of debt accumulation to take hold. However, as we already highlighted, policymakers are taking steps to end the most severe economic slowdown since the first half of the 1990s. China is currently implementing a middling stimulus program. The positive impact of the lower bank reserve requirement ratio, the tax cuts and increased public infrastructure spending is being mitigated by strong regulatory constraints on the shadow banking system and small financial institutions, by efforts to limit real estate speculation, and by the cash crunch facing real estate developers. These crosscurrents make it unlikely that the credit impulse will rise as sharply as it did following the reflationary campaigns of 2009, 2012 or 2016. Nonetheless, the Chinese economy is indeed exhibiting some mildly positive signals. Our monetary indicator and state-owned enterprise capital spending point to a rebound in overall Chinese economic activity (Chart 14). Moreover, household spending is trying to bottom. If China stabilizes, then the EM slowdown will end soon. Without a deepening drag from the Chinese economy, EM countries should be able to take advantage of the easing in global financial and liquidity conditions. But the end of the Chinese drag on EM growth does not mean a massive tailwind will be forthcoming. Additionally, deflationary forces remain stronger in the emerging world than in the US. As a result, EM real rates will remain stubbornly above the level that real economic activity warrants, posing a headwind for capital and durable goods spending. Generally speaking, EM and China are moving from a headwind for the world to a mild tailwind. Treasury yields are unlikely to move significantly higher than the 2.25% to 2.5% zone. Ms. X: I’m somewhat more positive than you on global growth next year. The policy easing around the world looks very promising for economic activity. How do you factor the impact of improving global liquidity conditions into your outlook for 2020? BCA: It is undeniable that global liquidity conditions have eased massively. As we already highlighted, the majority of global central banks cutting rates is a very positive dynamic for global growth. Trends in measures of liquidity ratify this message. Foreign exchange reserves are again growing and our BCA US Financial Liquidity index has rallied sharply over the past 12 months. Historically, this indicator forecasts the trend in the BCA Global Leading Economic Indicator, commodity prices and EM export prices by 18 months (Chart 15). Moreover, money aggregates are growing faster than credit across the major advanced economies. Such developments typically foretell an acceleration in global economic activity (Chart 16). Chart 15Liquidity Dynamics: Fueling A Global Growth Recovery Chart 16Rising Money Supply Is A Good Thing   The duration of the current slowdown also warrants optimism. We have often highlighted that since the early 1990s, the global manufacturing sector evolves over 36-month symmetric cycles (Chart 17). The current soft patch has lasted more than 18 months. In the context of easing liquidity and depleted inventories, pent-up demand can easily translate into actual spending. The recent surge in the new orders-to-inventories ratio confirms that global manufacturing activity should soon pick up (Chart 18). The auto sector’s weakness, which was exacerbated by previous inventory buildups, changing emission standards, and rising borrowing costs, is also ebbing. Chart 17The Mid-Cycle Slowdown Is Long In The Tooth Chart 18The New Order-To-Inventory Ratio Points To A Global Rebound     Various growth indicators are sniffing out this positive inflection point. The recent trough in the global ZEW survey is revealing (Chart 19). It materialized quickly after Sino-US trade tensions began to ease. Enough positive global economic momentum exists such that a minor decline in policy uncertainty could unleash a large improvement in growth expectations. The rebound in Taiwanese equities and European luxury stocks confirms that the global economy should soon bottom. There are two things we cannot emphasis enough. First, this is the end game of the business cycle, after which a recession will ensue. Second, investors should not expect the kind of strong synchronized growth rebound witnessed in 2017. Without a Chinese and EM boom, a crucial source of demand will be wanting. Mr. X: What about US growth? The yield curve inverted this summer and deteriorating consumer and business confidence raised the specter of an imminent recession. Moreover, the fiscal stimulus that helped the economy in the first half of 2019 is now over. In fact, with a $1 trillion federal deficit despite an unemployment rate of only 3.6%, we have run out of fiscal room to support activity if and when a recession materializes. BCA: The recent yield curve inversion most likely overstated the risk of an economic contraction. First, in the mid-1990s, if the term premium had been as low as it is today, the curve would have also inverted without any recession materializing from 1995 to 2000. Second, this summer, the curve inverted up to the 5-year tenor and steepened for longer maturities. Prior to recessions, the curve inverts across all maturities. Recessions are not born out of thin air. They are caused by imbalances and tight monetary policy. The large debt buildup and other investment imbalances that have preceded prior US recessions are not yet apparent. Prior to the 1991, 2001 and 2008 recessions, the private sector debt load had increased by 20.6%, 14.6% and 25.6% of GDP in the previous five years, not the current 1.4% run rate. The Fed’s policy is now clearly accommodative. Not only is the real fed funds rate 74.4 basis points below the Fed’s favored estimate of the neutral rate of interest, but also real estate, the most interest-rate sensitive economic sector, is rebounding. In 2018, real estate activity collapsed in response to mortgage rates rising to 4.9%. Today, the NAHB Homebuilding index has retraced 79% of its losses; mortgage demand has improved; and housing starts and building permits have recovered (Chart 20). When policy is tight, real estate activity never recovers this quickly, even as yields fall. Chart 19Positive Signals For Global Growth Chart 20The Housing Market Signals That Policy Is Accommodative   Chart 21Robust Household Financial Health A counterargument is that real estate price appreciation is weak. However, tight monetary policy is not the cause. Two forces are dampening house prices. First, the Jobs and Tax Act of 2017 lowered allowable mortgage interest and state and local tax deductions. High-end properties in high-tax states such as California, New York and Massachusetts have suffered from this adjustment. Second, the US housing market has an overhang of large, pricey homes relative to strong demand for smaller, starter homes. Median home prices outpacing average ones show this divergence. We also to need to gauge if consumer spending is likely to follow the manufacturing sector lower. If it does, a recession will be unavoidable. On this front, we are hopeful because: The outlook for household income is positive. As you noted, the unemployment rate is still extraordinarily low, and more Americans will be working by the end of 2020 than today. Additionally, the rising employment-to-population ratio for prime-age workers is tightly linked to stronger wages (Chart 21). Also, the recent pick up in productivity growth points to higher real wage growth. The household savings rate is elevated and has limited upside. Households already have a large cushion insulating them from unforeseen shocks. At 8.1% of disposable income, the savings rate is in the 65th percentile of its post-1980 distribution. It is especially lofty if we take into account robust American households’ net worth (Chart 21, bottom panel). Consumer credit demand is rising, according to the Fed’s Senior Loan officer survey. Since household liquid assets are quickly expanding and the household formation rate is robust, consumption of durable goods should pick up, especially in light of the large decrease in borrowing costs. This is particularly true since the household debt-to-assets ratio is at its lowest level since 1985 and debt-servicing costs only represent 9.7% of disposable income, the lowest share for nearly 40 years. The corporate sector outlook should brighten soon. The modest rise in productivity protects margins from higher wages, an effect that will linger given that capacity expansion is consistent with further productivity gains (Chart 22). Crucially, the combined fiscal and monetary easing in China should bolster capital-spending intentions around the world, including the US (Chart 23). Rising productivity will only consolidate these trends. Chart 22Capacity Growth Provides Some Support For Productivity Chart 23Chinese Reflation Will Revive US Capital Spending   The most positive development for the US corporate sector is our outlook for non-US growth. If the global manufacturing sector mends itself, so will the US. Ample liquidity is a positive for the world economy, as well as for US manufacturing conditions (Chart 24). On the fiscal front, we appreciate your worries, but they are not a story for 2020. The US fiscal thrust will not be as positive as it was in 2018 or 2019, but it is set to remain a small tailwind, not a drag. Furthermore, given that 2020 is an election year it is unlikely that politicians will tighten purse strings over the coming 12 months. Fiscal risks are undoubtedly greater in the long run. However, a sudden fiscal consolidation is a remote probability because fiscal austerity has gone out of style. Instead, the federal debt burden will be a major source of long-term inflation because there is no other easy way to address this gigantic pile of liabilities. The path of least resistance will be more spending and financial repression. In other words, real rates will stay too low and excess government spending will push prices higher, conveniently eroding the real value of that high federal debt burden. This was a big story in the 20th century and it will remain so in the 21st (Chart 25), especially since an aging population and the peak in globalization will weigh on global savings. Chart 24The US Manufacturing Slowdown Has Run Its Course Chart 25Inflation Is About Political Decisions   Ms. X: Your point about demographics makes me think of Europe and Japan. Brexit has not been resolved; populism remains a concern in Italy; and the European banking system is still fragile. Japan suffers from an even worse demographic profile and the recent VAT increase was ill-timed, economically. Given these headwinds, can these regions participate in the global recovery you foresee? BCA: The short answer is yes, albeit to varying degrees. The outlook for Europe is more promising than Japan. A No-Deal Brexit is now a very low probability event, even after next month’s UK election. The conservatives’ support for Prime Minister Johnson’s Brexit plan will ensure as much. A large source of uncertainty is being lifted, which will allow European businesses to resume investment planning. The situation in the European periphery is also improving. Non-performing loans in Spain and Italy are falling (Chart 26), which is allowing for a normalization of credit origination. The narrowing Italian and peripheral spreads to German bunds will be helped by easing financial conditions in the European economies that need it most. Higher Italian bond prices improve banks’ solvency and cut borrowing costs for the private sector. Finally, populism is alive and well in Europe, rejecting fiscal austerity, but not embracing euro-skepticism. More generous fiscal spending would be a positive for Europe. European liquidity conditions are also generous. Deposit growth has strengthened and financial conditions have benefited from lower German yields and a cheap euro, which trades 15% below fair-value estimates. Our model for European banks’ return on tangible equity is rising, which is a clear indication that easy financial and liquidity conditions should deliver stronger incremental economic activity (Chart 27). Chart 26Declining Non-Performing Loans Are A Positive For The European Periphery Chart 27European Banks' Return On Equity Will Improve In 2020   The fiscal outlook is murkier. European fiscal thrust was a positive 0.4% of GDP in 2019, but it will decline to 0.1% in 2020. However, fiscal policy affects economic activity with a lag. The impact of this year’s easing has yet to be fully felt. Since European rates are so low and the economy is not operating at full capacity, the fiscal multiplier is greater than one. Therefore, Europe can still reap a substantial fiscal dividend next year. Finally, Europe remains a very pro-cyclical economy. A large share of euro area GDP is connected to manufacturing and exports. As a result, Europe will be one of the prime beneficiaries of a pickup in global growth. Already, the sharp rebound in the German and euro area ZEW survey expectation components point to a brighter outlook for the region. Japan is also a very pro-cyclical economy, which will reap a dividend from a bottom in global manufacturing activity. However, the Land of the Rising Sun is still subject to idiosyncratic constraints. Japanese financial conditions have not improved as much as those in Europe. The yen has appreciated 2.6% in trade-weighted terms this year, while Japanese yields have not melted as much as European ones (because Italian and peripheral yields fell so much in 2019). Japan will also have to reckon with the impact of the October VAT increase. Ahead of the tax hike, retail sales spiked by 9.1% on a year-on-year basis, or 7.1% compared to the previous month, a script similar to 2014. 2015 was a payback year where consumption was depressed. This scenario will play out again, even if the Abe government has implemented some fiscal offsets. Ultimately, the Japanese economy will lag Europe’s in the first half of the year but should catch up in the second half. The impact of the tax hike will dissipate. Most importantly, rebounding global growth will hurt the yen, at least on a trade-weighted basis, providing a lift to export prospects and easing Japanese financial conditions relative to the rest of the world, which will produce a growth dividend later in 2020. Ms. X: To summarize, you expect a moderate rebound in global growth next year, but not a sharp acceleration because Chinese stimulus will not be that aggressive. EM activity will also pick up but will not generate fireworks. The US will be okay but Europe will probably deliver the largest positive growth surprise as external and domestic conditions align positively. Japan will also stabilize on the back of stronger global growth, but domestic headwinds mean that a true reacceleration won’t happen until the latter part of the year. This recovery constitutes the business cycle’s end game as inflation will become a concern in 2021, forcing the Fed to tighten then. BCA: Yes, this is correct. Ms. X: Thank you! Bond Market Prospects Chart 28Global Bonds Are Extremely Overvalued Ms. X: I do not like US Treasuries at current yields. They do not protect me against an inflation surprise and will do nothing for me in an economic recovery. However, my bearishness is tempered by the large stock of bonds with negative yields in Europe and Japan. As long as this strange situation persists, I doubt US yields will experience much upside. US paper is too attractive to foreign asset managers right now. BCA: We share your view and are recommending an underweight to global government bonds. Global yields offer little value and are vulnerable to a rebound in economic activity or a trade détente. Our Global Bond Valuation index is flashing a clear sell signal (Chart 28). As yields rise, global yield curves are bound to steepen. We also agree that the upside for Treasury yields is limited, but we disagree with the limiting factor. Foreign investors are not the major buyers of Treasuries. Indeed, the data shows that European and Japanese investors have not been aggressive purchasers of US government securities. The US yield curve is flat and US short rates tower above European and Japanese ones, hedging currency exposure when buying Treasuries is expensive. In euro or yen terms, a hedged Treasury yields -67 basis points and -60 basis points, less than 10-year bunds or JGBs, respectively. Meanwhile, EM central banks are diversifying their FX reserves away from the US dollar into gold. Instead, our view is governed by the concept we dub the “Golden Rule of Treasury Investing.” According to this principle, the outperformance of Treasuries relative to cash is a direct function of the Fed’s ability to surprise the market. If the Fed cuts rates more than the OIS curve anticipated 12 months prior, Treasuries outperform. The opposite happens if the Fed delivers a hawkish surprise (Chart 29). Chart 29The Golden Rule Of Treasury Investing Treasury yields are unlikely to move significantly higher than the 2.25% to 2.5% zone, because the OIS curve is now only pricing in 28 basis points of rate cuts over the next year. It is not just the US OIS curve that has priced out a large amount of rate cuts; this phenomenon has materialized around the world over the past five weeks. Chart 30The Term Premium Is Too Low Any upside risk to that 2.25% to 2.5% forecast for 2020 will come from the inflation expectations and term premium components of yields. Central banks, including the Fed, have telegraphed an intention to allow inflation expectations to rise, initially, in response to stronger global growth. Moreover, declining risk aversion should also allow the exceptionally depressed term premium to normalize (Chart 30). Only in late 2020 or early 2021 will Treasury yields durably move above this 2.25-2.5% zone. Punching above these levels will require core PCE inflation to have been above target long enough to re-anchor inflation expectations back up to their 2.3% to 2.5% target zone. Only then will the Fed give the all-clear signal to the bond market to lift yields higher. Mr. X: You still have not directly addressed the question of negative yields in Europe and Japan. This story will not end well. Do you worry about these bond markets over the next year? BCA: Our answer is an emphatic yes. But we assume you will not let us leave it at that. Mr. X: You know me too well. BCA: Over the course of the past 50 years, we have learned a thing or two about you. In all seriousness, let’s start with our simple but effective valuation ranking. It compares the current level of real yields for each country to their historical averages and standard deviations. You can see that the most unattractive bond markets right now are all in Europe (Chart 31). Chart 31European Bonds Are Too Dear Chart 32Swiss Bonds Are A Lose-Lose Proposition The lower bound of interest rates is another reason to avoid these markets. This floor seems to lie around -1% in nominal terms. Because of these constraints, in recent months, Swiss, Swedish, Dutch and German 10-year bonds have failed to rally as much as their higher-yielding US, Canadian or Australian counterparts when global yields are declining. However, they also underperform when yields are rising (Chart 32). They have become a lose-lose proposition. The only pockets of value left in DM bond markets are Greece, Portugal or Italy. Despite their apparent risks, we still like them. Support for the euro in Greece and Italy is 70% and 65%, respectively. Even populist governments in these nations are reluctant to attack euro membership anymore. Moreover, the ECB remains committed to the survival of the euro area in its current form. Christine Lagarde will not change that. For 2020 or 2021, the risk of euro breakup is practically zero. The same may not be true on a 5- to 10-year investment horizon, but for the coming year, these bonds offer an attractive risk-adjusted carry. Ms. X: Unsurprisingly, my father does not like corporate bonds because of highly levered corporate balance sheets. I think this is a long-term problem, but not a risk for 2020, so I’m looking to stay overweight spread product relative to Treasuries. Where do you stand on this market? BCA: On this issue, we sit somewhere between you both. Our Corporate Health Monitor continues to deteriorate (Chart 33). The high debt load of the US business sector coupled with the decline of the return on capital worries us. Furthermore, the covenant-lite trend in recent issuance suggests that corporate borrowers, not lenders, are getting the good deals. Essentially, too much cash is still chasing too little available yield pick-up. In this environment, capital is sure to be misallocated, and money ultimately lost. We find the reward-to-risk tradeoff more attractive in Europe and Japan than in emerging markets. On a short-term basis, the spreads will not widen much. An easy Fed, recovering global growth, and the gigantic pile of negative-yielding bonds around the world will make sure of that. We advocate a neutral stance on investment grade corporates because IG bonds have high modified duration such that breakeven spread compensation versus Treasuries is near the bottom of its historical distribution across the IG credit spectrum (Chart 34). This means that credit will generate poor returns if government bond yields rise. Chart 33Dangerous Long-Term Picture For US Corporates Chart 34No Value Left In IG   Chart 35EMs Still Experiencing Deflation Thankfully, they are ways around this problem: emphasizing exposure to high-yield (HY) bonds and agency mortgage-backed securities (MBS) instead. HY breakeven spreads remain much more attractive than in the IG space, and option-adjusted spreads will benefit if our growth and inflation forecasts materialize. Investors reluctant to commit capital to these products should look into high quality agency MBS. After the recent wave of mortgage refinancing, these securities’ duration has collapsed to 3.0 compared to 7.9 for IG corporates. These securities therefore offer much better protection in a rising-yield environment. Ms. X: Before we move on to equities, where do you stand on EM bonds? BCA: We need to differentiate between EM local-currency bonds and EM USD-denominated bonds. We do like some EM local currency bonds. Inflation in EM countries is low and dropping. Money and credit growth is slowing, which implies that the disinflationary trend will remain in place through 2020 (Chart 35). Weaker nominal growth means that central banks in EM will continue to cut rates, providing a nice tailwind for local-currency bond prices. This comes with a caveat. Lower policy rates will boost bond prices but hurt EM currencies, especially because most EM currencies are not cheap and are already over-owned. Next year, it will be preferable to garner exposure to those countries interest rate moves via the swap market rather than the cash bond market. Chart 36The Mexican Peso Is Cheap There are some exceptions, like Mexico. The MXN is already very cheap because of fears surrounding the economic policies of President Andres Manual Lopez Obrador (AMLO) (Chart 36). However, we doubt he will turn out to be as dangerous as feared. Hence, MXN Mexican bonds are attractive to foreign investors in unhedged terms. We are currently avoiding EM USD-denominated debt, corporate and sovereign. Since emerging markets sport $5.1 trillion of dollar-denominated debt, falling EM exchange rates will increase the cost of servicing this debt, which makes it riskier. Mr. X: I think we will continue to underweight corporate and EM bonds in our fixed income portfolio. Spread levels still make no sense in terms of providing compensation for credit risk. I must admit that I find your recommendation to overweight MBS intriguing. We will need to ponder this idea further. Ms. X: And please wish me luck trying to convince my father to buy some high-yield bonds. Equity Market Outlook Mr. X: US stocks are too expensive for my taste, with the S&P 500 trading at a forward P/E ratio of 18. I’m well aware of the argument that equities may be expensive but that they are actually cheap compared to bonds, which implies that I should favor stocks over bonds. However, you know that I emphasize capital preservation. With stocks this rich already, equities offer no margin of safety. If I own stocks, I am therefore exposed to any unexpected shocks. Because I do not share your optimism on the economy, I am more worried about downside risk. Moreover, even if the economy performs better than I fear, I suspect stocks will respond poorly to higher yields. Chart 37The S&P Is Very Expensive Ms. X: I agree with my father that stocks are expensive. Nonetheless, as Keynes famously quipped, “Markets can stay irrational longer than you can stay solvent.” In today’s context, to me this means that stocks can ignore their overvaluation so long as liquidity is plentiful, rates are low, and a recession is avoided. BCA: On this question, we agree with Ms. X. We all agree that US equities are expensive. As you mentioned, their price-to-earnings ratio is 18. Only at the apex of the tech bubble and in early 2018 was the S&P 500 more expensive. Worryingly, the price-to-sales ratio is at 2.3, an even larger historical outlier than the P/E (Chart 37). Chart 38Low Yields And Plentiful Liquidity Are Still Fertile Ground For Stocks Ms. X is correct that we cannot look at stock valuations in isolation. Investing is about opportunity cost and the macroeconomic context. On this front, even US equities have their merit. Despite the S&P 500’s expensive multiples, our Composite Valuation Indicator is no more elevated than it was in 2013. Meanwhile, our Monetary Indicator has rarely been as supportive of stock prices as it is today, and our Speculation Indicator is in line with its January 2016 reading (Chart 38). Moreover, BCA’s Composite Sentiment indicator is still below its long-term historical average and margin debt has declined by $47.5 billion to the lowest share of US market capitalization since June 2005. These are hardly signs of irrational exuberance. Ultimately, bear markets and recessions travel together. A durable 20% drop in stock prices requires a significant and long-lasting decline in earnings. These developments happen during recessions (Chart 39). Our call is for a recession in the next 24 months or so. We must also remember that while equities perform poorly six months ahead of a recession, the end of a bull market, its last 12 to 18 months, tend to be very rewarding (Table 3). We are within this window. Chart 39Bear Markets And Recessions Travel Together Table 3The End Game Can Be Rewarding Based on our forecast for interest rates, we do not share the concerns that rising bond yields will topple stocks right away. Stock prices are an inverse function of risk-free rates, but a positive function of growth expectations. Higher yields will initially reflect stronger growth, not restrict it. But remember: the upside for yields is limited because central banks do not want to choke off the recovery. They will maintain accommodative policy. In other words, we expect real rates to lag behind growth expectations. Because long-term growth expectations, whether from sell-side analysts or extracted out of market prices using the Gordon Growth Model, are low, we are willing to make this bet (Chart 40). Equities will suffer if the global bond yield rises above 2.5%. This is more a story for 2021, and not our central scenario for 2020. It is nonetheless a reminder that we are entering the end game of the business cycle, so we are also entering the end-game of the bull market. Mr. X: I think you are playing with fire. Stocks are so expensive that if you are wrong on either the growth call or the yield call, they will suffer. I would rather miss the last melt-up in stocks than unnecessarily expose my portfolio to a meltdown. Additionally, you have not addressed the fact that S&P 500 margins have begun to soften but are still extremely elevated. Shouldn’t this dampen your optimism? BCA: Aggregate S&P 500 margins have some downside. Our Composite Margin Proxy, Operating Margins Diffusion index and Corporate Pricing Power indicator all remain weak (Chart 41). The deceleration in the crude PPI excluding food and energy and the past strength in the dollar confirm this insight, especially as the corporate wage bill climbs in a tight labor market. The biggest mitigating factor is that productivity is also on the mend, which curbs the negative impact of higher worker pay. Chart 40Growth Expectations Are Muted Chart 41US Margins Under Pressure   This danger must be put into perspective though. Margin expansion has been dominated by the tech sector (Chart 42). Excluding this industry, S&P 500 margins are roughly in line with their previous peak, and are not declining. The aggregate softness in margins is a reflection of the sharper decline in tech margins. Declining margins do not spell the imminent end of the bull market either. Table 4 shows that on average, the S&P 500 rises by 9.5% following the peak in margins. Equities can rise after margins crest because this is often an environment where wages are climbing, which boosts consumption. Consequently, top-line growth can accelerate and earnings can rise even if they represent a lower proportion of sales. This is the environment we foresee over 2020. Chart 42Tech Margins Have Likely Peaked Table 4Margin Peaks Do Not Spell S&P Doom   Chart 43Taiwanese Stocks Are Sniffing Out Better Global Growth Ms. X: You have talked about the tech sector being a drag on overall margins. How would you position a US stock portfolio? BCA: First, around the world, we prefer cyclical sectors to defensive ones. Cyclical stocks are depressed relative to defensive firms’ shares. Rebounding global growth and rising bond yields will favor cyclical sectors. Globally, the performance of cyclical equities relative to defensive ones correlates with Taiwanese equities, which are currently rallying smartly (Chart 43). This suggests that at the margin, the most cyclical asset markets are beginning to express optimism about global growth. Within the S&P 500, our favorite pair trade to express this bias is to overweight energy stocks at the expense of utilities. Utilities are bond proxies which will substantially underperform energy stocks when the rate of change of Treasury yields moves up (Chart 44). Moreover, based on our valuation indicators, energy stocks have never traded at such a deep discount to utilities, nor have they ever been as oversold. Chart 44Favor Energy Over Utilities Second, we are currently neutral on tech stocks but have put them on a downgrade alert. Tech equities are expensive, trading at a forward P/E ratio 21% above the other cyclicals. Moreover, since software spending has remained surprisingly resilient despite the global economic slowdown, it will likely lag investment in machinery and structures when industrial demand rebounds. Consequently, tech earnings will lag other traditional cyclical sectors. Tech multiples will also suffer when bond yields rise. As high-growth stocks, tech equities derive a large proportion of their intrinsic value from long-term deferred cash flows and their terminal value. Thus, tech multiples are highly sensitive to changes in the discount rate We implement this view by way of an underweight in tech and an overweight to industrials. Industrials have suffered disproportionately from the trade war. Any near term truce is unlikely to contain a grand bargain on intellectual property rights transfer that galvanizes tech exports, but it will remove some of the uncertainty weighing on industrials. Moreover, industrials are a much cheaper play on a global growth rebound. The global manufacturing slowdown has caused industrial equities to trade at their greatest discount to the tech sector since the financial crisis. Finally, the wage bill for the industrial sector is melting relative to tech, and our margin proxy is surging (Chart 45). This has created a very positive backdrop for this pair trade. We also like financials. They will be a key beneficiary of rising yields and a steepening yield curve. Additionally, household credit demand has picked up and overall credit growth should accelerate as central banks will maintain very accommodative monetary conditions. The yield impulse already points toward higher bank credit growth and companies are issuing an increasingly large stock of bonds (Chart 46). Chart 45Operating Metrics Will Boost Industrials Versus Tech Equities Chart 46Easing Financial Conditions Will Support Credit Creation   Ms. X: When combining valuation analysis with your fundamental sectoral slant, I am guessing that you must favor European, Japanese and EM stocks over the S&P 500? BCA: We do favor European and Japanese equities. Based on valuation alone, all the regions you mentioned offer higher expected long-term real rates of return than the US (Chart 47). Moreover, the dollar is expensive relative to advanced economies’ currencies. Hence, these markets are cheaper vehicles than the S&P 500 to bet on a global economic recovery. But valuation alone is not enough. US stocks are trading at unprecedented levels relative to global equities because of the FAANG craze (Chart 48). Looking at sector representation, our positive view on non-tech cyclicals also flatters exposure to Europe and Japan (Table 5). Chart 47Non US Equities Offer Better Value Chart 48FAANG-Driven US Outperformance   Table 5Equity Market Sector Composition Chart 49European Banks Are Cheap Europe is particularly attractive because of its large skew towards industrials and financials, which represent 32.3% of the market versus 22.3% in the US. Moreover, European financials are also a tantalizing bet because they trade at a 50% discount to US financials, according to their price-to-book ratio. Additionally, their return on tangible equity will benefit from higher German yields, easing financial conditions, declining non-performing loans in the periphery and rebounding global growth. Our RoE model for European banks already points to a resurgence in their stock prices (Chart 49). Of the major markets we track, Japan offers the highest prospective long-term real returns. Its strong cyclical slant and low share of tech stocks means it is another market investors should overweight to bet on a global recovery. The biggest problem for Japanese equities is the yen. When global yields climb higher, a weak JPY will clip some of the Nikkei’s gains for foreign investors. Finally, we are reluctant to overweight EM stocks just yet. In this space, median P/E ratios are much higher than on a market capitalization-weighted basis (Chart 50). State-owned companies explain this bifurcation, Chinese banks in particular. Since we expect Chinese banks to remain a conduit for policy, credit origination may flatter economic growth more than shareholders’ interests. Moreover, we have a negative outlook on EM currencies, and hedging this exposure is expensive. Finally, if China’s economic activity improves only modestly in 2020, the 2012 experience suggests that EM stocks can still underperform the global equity universe as global growth improves and yields rise (Chart 51). In other words, we find the reward-to-risk tradeoff more attractive in Europe and Japan than in emerging markets. Chart 50EM Stocks Are No Bargain Yet Chart 51EM Stocks Can Underperform When Global Growth Improves     Mr. X: Thank you. I am still not sure what share of our portfolio will be dedicated to stocks. However, I think that whatever this proportion will be, buying global equities makes more sense than US ones. Your valuation argument alone is swaying me, considering my more conservative instincts. Ms. X: I’m glad we will not have to argue on this point, but I know we will nonetheless battle on the stock/bond/gold split. Should we move on to your currency and commodity forecasts? BCA: It would be our pleasure. Currencies And Commodities Mr. X: You have often argued that the dollar is a countercyclical currency. Based on our discussion so far, you must expect the dollar to decline until we get closer to the next recession. I am not fully convinced. Specifically, I remember that in the back half of 2016 global growth was rebounding, but the dollar soared. Therefore, the growth/dollar relationship can be more complex than you argue. Meanwhile, with negative interest rates in Europe, Japan and Switzerland, why would I even consider divesting out of my positive yielding dollar assets? Chart 52The Dollar Is A Counter Cyclical Currency BCA: You raise interesting questions, and you are correct that we expect the dollar to depreciate if our constructive view on global growth pans out for 2020. The inverse relationship between global industrial production (excluding the US) and the trade-weighted dollar is unambiguous (Chart 52). As you also mentioned, the reality is a little bit more nuanced. To understand why, it is important to remember how currencies function. We can think of an exchange rate as an adjustment mechanism that solves for the gap in growth between any two countries. This is at the root of the dollar’s counter-cyclicality. When global growth is picking up, returns tend to be higher in cyclical markets, which are highly concentrated outside of the US. Flows then gravitate from the US to other markets and the dollar declines. After a while, the dollar becomes cheap enough that these flows reverse. In the second half of 2016, three factors drove the dollar rebound. First, US manufacturing was improving at a faster pace than that of the rest of the world. Second, the Fed resumed its interest rate hikes, so interest rate differentials suddenly flattered the dollar anew. Finally, the election of President Trump, who campaigned on large scale fiscal stimulus, elicited memories of the Reagan dollar bull market of the first half of the 1980s. These factors eventually faded as global growth rebounded. Today, the Fed’s policies are hurting the dollar. Aside from recent interest rate cuts, the Fed has been injecting liquidity into the banking system through repurchase agreements and renewed asset (T-Bills) purchases. Moreover, the rate cuts are also easing global funding conditions and promoting a re-steepening of the yield curve. This will incentivize banks to lend and boost the US money supply. As growth re-accelerates and demand for imports (machinery, commodities, and consumer goods) rises, the current account deficit will widen further. This process will increase the international supply of dollars. Historically, these dynamics usually hurt the dollar. What we have described is a tentative abatement in geopolitical risk at best – but it would be cavalier to get overly enthusiastic. Like you, we are deeply uncomfortable with negative interest rates. Thankfully, the nascent pickup in global economic activity is lifting global bond yields. So far, foreign bond markets have led this move. More specifically, countries that have suffered most from the global manufacturing slowdown are now seeing their bond yields rise the quickest (Chart 53). For example, yields in Germany, Norway, Sweden, Switzerland and Japan have risen by a lot more than those in the US since global yields troughed in September. Should the initial signals of stabilization in global growth morph into a synchronized recovery, the US yield advantage will evaporate. In a nutshell, interest rates might be negative in Europe and Switzerland, but the positive carry offered by US assets is rapidly fading. Chart 53AAre Interest Rate Differentials Flashing A Signal About Exchange Rates? Chart 53BAre Interest Rate Differentials Flashing A Signal About Exchange Rates?   Chart 54Foreigners Are Selling Treasuries For international investors, the currency risk inherent in owning US bonds is just too large at the current juncture. Remember, the trade-weighted dollar stands 25% above its long-term equilibrium and the US twin deficits are expanding. Markets priced in cheap currencies with some potential upside, such as Australia, Canada, Norway or even the European periphery, might be better bets. Flows highlight just how precarious the situation is for the US dollar. Since last August, overall flows into the US Treasury market have been negative. Net foreign purchases by private investors are still positive at an annualized US$180 billion, but they are clearly rolling over. Moreover, official net outflows are running at $350 billion, easily cancelling out the private sector’s inflows (Chart 54). Essentially, foreigners’ appetite for US fixed-income assets is waning exactly as interest rate differentials have started moving against the dollar. Ms. X: I share my father’s concerns, but how would you implement your negative dollar view. Which currencies should I be loading up on as we enter the business cycle’s end game? BCA: The more export-dependent economies (and currencies) should benefit the most from a rebound in global growth. Within the G-10, we particularly like the Swedish krona, the Norwegian krone and the British pound. Bond yields for these currencies are rising the fastest vis-à-vis the US. As a result, the currencies themselves should soon follow (previously mentioned Chart 53). We also expect commodity currencies to benefit, but only upon clearer signs that the resource-thirsty Chinese economy is improving. Until then, they are likely to lag the pro-cyclical European currencies, which are less directly dependent on Chinese stimulus. The euro could become the greatest beneficiary from a weaker dollar because a large headwind for European economic activity is disappearing for now. For the past ten years, European real interest rates have been too low for the most productive, competitive exporter – Germany – but too high for others such as Spain and Italy. Consequently, the euro has been caught in a tug-of-war between a rising neutral rate of interest for Germany and a very low one for the peripheral economies. Via its rate cuts, asset purchase programs, and aggressive TLTRO packages, the ECB may have now finally eased policy to the point where nearly all Eurozone countries enjoy an accommodative monetary environment. 10-year government bond yields in France, Spain, Portugal and even Italy now all sit close to the neutral rate of interest for the entire eurozone (Chart 55). Chart 55The ECB Has Eased Policy Enough Finally, the euro is likely to benefit from inflows into European equity markets. The euro’s drop since 2018 has eased financial conditions and made euro area businesses more competitive. This is an important tailwind for European corporate profits and thus stocks. Moreover, European equities, especially those in the periphery, remain unloved, as illustrated by their cheap valuations compared to other advanced economies. Additionally, analysts’ earnings expectations for eurozone equities are perking up relative to US stocks. If the sell-side is right, powerful inflows into the region will lift the euro in 2020. Mr. X: Thank you. I find it difficult to share your enthusiasm for the euro, a currency backed by such a flimsy edifice. While I would agree that it could rebound next year, I find currencies highly unpredictable on such a time horizon. I prefer to think about them on a long-term basis, and while the euro is cheap, its weak institutional underpinning is too concerning. Let’s move on to commodities. Following our meeting last year, we took your advice on oil and gold. Overall, these calls helped our portfolio. Going forward, these markets are extremely perplexing. There is so much risk in oil markets, such as the tensions in the Middle East and the uncertainty stemming from the trade war between the US and China. How would you recommend playing the oil market in 2020? Chart 56Inventory Drawdown Will Support Oil BCA: Your assessment of these markets is spot on. Yet, price risk is skewed to the upside because fiscal and monetary stimulus will revive commodity demand. The oil-producer coalition led by Saudi Arabia and Russia will continue to restrain production, and will probably extend its 1.2mm b/d production cut due to expire at the end of March to year-end 2020. In the US, market-imposed capital discipline will keep reducing the growth of US shale-oil supply. Additionally, US shale-oil supply growth is threatened by flaring of associated natural gas in the Bakken and Permian basins. Failure to limit the burn-off at oil-production sites could provide the environmental lobby an opening to challenge growth. Ms. X: What about the demand side of the oil markets? The fall in the growth rate of demand this year caught most participants off guard. What do you make of that? BCA: Demand data shows a lot of lingering weakness, much of which was caused by tight financial conditions last year in the US and China. But now, most global central banks are pursuing highly accommodative monetary policy and many governments are also easing fiscal policy. As a result, this demand weakness will fade next year. We think next year growth will clock in at 1.4mm b/d. Not as robust as 2017, but still respectable. This should stop the downward pressure on oil prices that has prevailed since May (Chart 56). Mr. X: You’re describing a fairly strong market for next year. What are the downside risks to your view? BCA: Global economic policy uncertainty remains elevated. Uncertainty is one of the key factors driving demand for USD, which is one of the most popular safe havens in the world (Chart 57). A strong dollar creates a headwind for commodity demand. It raises the local-currency costs of consumers in the EM economies that drive oil demand, and lowers production costs outside of the US, encouraging supply growth at the margin. Chart 57Elevated Global Economic Uncertainty Has Kept The USD Well Bid Chart 58Gold: A Valuable Portfolio Hedge Ms. X: So, pulling it all together, what is your call for 2020? BCA: The weaker 2019 demand data and the upward revisions to global oil inventories pushed our 2020 Brent Oil forecast to $67/bbl from $70/bbl. We still expect WTI to trade at a $4/bbl discount to Brent. As we mentioned earlier, the risk to our forecast is to the upside: a resolution of the US-China trade war, and lower global economic policy uncertainty could trigger a sharp rally in crude prices. Mr. X: Thank you for your insight on oil. I would like to hear your thoughts on gold. You can tell that I see little absolute value in stocks or bonds at the moment, so I have an outsized preference for the yellow metal this year. Also, how could the US dollar and gold both rally at the same time in 2019? BCA: Let’s start with your dollar/gold question. It is very rare to see gold and the dollar rally together. Normally a strong dollar hurts gold. As you know, we’ve been recommending an allocation to gold since 2017, mostly as a portfolio hedge. We like that gold strongly outperforms other safe havens in equity bear markets and can participate in the upside (even if to a limited extent) in bull markets. We think the safe-haven properties of gold and the US dollar really have come to the fore over the past couple of years (Chart 58). Economic policy uncertainty, and divisive politics globally have raised the level of uncertainty to record levels. In such an environment, the dollar and gold both provide a safe haven and a portfolio hedge. Hence, their joint popularity this past year. We should also remember that gold is a good inflation hedge, and is particularly negatively correlated with real interest rates. A Fed that is willing to let the economy overheat is a Fed that will limit how high real rates climb. Moreover, global liquidity is plentiful. Finally, EM central banks have been slowly divesting from Treasuries and diversifying into gold lately, buying most of the new supply in the process. This backdrop, along with our forecast of a weaker dollar, should support gold again in 2020. That being said, because gold is tactically overbought and could face temporary headwinds if global uncertainty recedes, we prefer silver, which is not as stretched. Furthermore, silver’s higher industrial use means that it should also benefit from a global manufacturing recovery. Geopolitics Chart 59Multipolarity Creates An Unstable Environment Mr. X: Let’s return to geopolitical and policy risks, both of which abound. Global economic policy uncertainty is the highest it has been since academics began measuring it. The world is fraught with populism, authoritarianism, war, immigration, technological disruption, inequality, and corruption. With so much chaos, and so little consensus, is there anything solid for an investor to grasp about the political backdrop next year? BCA: Geopolitics is the likeliest candidate to short circuit this long bull market, given that the Federal Reserve, the usual culprit, has paused its rate tightening campaign. On a secular basis, geopolitical risk is rising because the United States’ national power is declining relative to that of other world powers (Chart 59). China’s rise, in particular, is stirring conflict with the US and its allies in the western Pacific. Beijing’s technological and military advance is generating fear across the American political establishment. Russia and China continue to deepen their relationship in the face of an increasingly unpredictable United States. These strategic tensions will persist despite any tariff ceasefire with China. Chart 60Globalization Has Peaked Competition among the great powers makes for a world of contested authority. As the rules of the road have become less certain, the tailwind behind international trade and investment has weakened (Chart 60). Deglobalization is a headwind for the earnings of large cap global companies in the long run. Emerging markets, which are exposed to trade, face persistent unrest. Mr. X: Given the above, how can an investor take an optimistic view of the global economy and markets next year? BCA: We have a framework for analyzing politics: constraints over preferences. We cannot predict what the chief politicians will prefer at any given time, but we can try to identify and measure the constraints that will restrict their freedom of movement. With global growth slowing, world leaders have become more sensitive to their constraints. The Fed has reversed rate hikes; China is easing policy; President Trump has refrained from attacking Iran; and President Trump and President Xi are negotiating a ceasefire. The UK has avoided a “no deal” Brexit – not once but twice. In short, the risk of recession (or conflict) has been sufficient to alter the policy trajectory. As a result, there is a prospect for global geopolitical risks to abate somewhat in 2020. Both the American and Chinese administrations need to see growth stabilize despite their ongoing strategic conflict. Both the British and European governments need to avoid a disorderly Brexit despite their lack of clarity beyond that. Geopolitical risk is declining, albeit from an extremely elevated level. Mr. X: The US and China have already come close to a deal only to get cold feet and back away from it. The British Prime Minister is committed to leaving the EU with or without a deal. Surely you cannot believe that the Middle East, Russia, other emerging markets, or North Korea will be any bastion of stability. BCA: The US-China trade war is still the single greatest threat to the equity bull market. Brexit is not resolved and a new deadline for a trade deal looms at the end of 2020. Investors must remain vigilant and hedge their portfolios, particularly with gold. Nevertheless, one cannot ignore this year’s reaffirmation of the Fed put, the China put, and Trump’s “Art of the Deal.” The base case for next year should be constructive, albeit with vigilant attention to the major risks: President Trump, China and Iran. The other issues you mention have varying degrees of market relevance. Russia is focusing on pacifying domestic discontent. North Korea is on a diplomatic track with the United States. Emerging market unrest is particularly relevant where it can have a bearing on global stability: Iraq, Iran and Hong Kong in particular. Ms. X: If I may interject: It seems to me that the worst of the trade war has passed, that the risk of a no-deal Brexit is negligible, and that Iran is unlikely to outdo its attack against Saudi Arabia in September. Doesn’t this imply that geopolitical risk is overrated and that investors should rush to capture the risk premium in equities? BCA: What we have described is a tentative abatement in geopolitical risk at best – but it would be cavalier to get overly enthusiastic. After all, any fall in global risks will be amply made up for by the impending rise in US domestic political risk. Indeed, US politics are the chief source of global political risk in 2020. First, if President Trump becomes a “lame duck” then he could take actions that are hugely disruptive to global markets in a desperate attempt to win reelection as a “war president.” Chart 61European Political Risk Is Now Low Second, if President Trump is reelected, then his disruptive populism will have a new mandate and his “America First” foreign and trade policy will be unshackled. Third, if the opposition Democrats succeed in unseating an incumbent president, they will likely take the Senate too, removing the main hurdle to a dramatic policy change. That would mark the third 180-degree reversal in national policy in 12 years. Moreover, investors may find the country merely exchanged right-wing populism for left-wing populism, which has a more negative impact on corporate earnings prospects. Polarization and institutional erosion will continue. The election results may be razor thin; swing states may have to recount votes; and the outcome could hinge on rare or unprecedented developments in the Electoral College, the Supreme Court or cyberspace. A crisis of legitimacy could easily afflict the next administration. In short, there are few scenarios in which US political risk does not rise over the next 12-24 months. Rising American risk stands in stark contrast to Europe (Chart 61), where the will to integrate has overcome several challenges since the sovereign debt crisis. Substantial majority of voters support the euro and the European Union. Germany is on the brink of a major political succession but it is not turning its back on the European project. France is successfully pursuing structural reforms. Italy remains the weakest link, but even the populist Northern League accepts the euro. This leaves two remaining global risks: China and Iran. Chinese political risk is generally understated. President Xi Jinping, lacking President Trump’s electoral constraint, could overestimate his leverage. He could overreach in the trade talks, in his battle to prevent excessive debt growth, or in his handling of Hong Kong, Taiwan, North Korea, or Iran. The result could be a breakdown in the trade talks or a separate strategic crisis with the United States. Another cold war-style escalation in tensions could easily kill the green shoots in global growth. As for Iran, the regime is under crippling American sanctions and faces unrest both at home and within its regional sphere of influence. There is a non-negligible risk that it will lash out and cause an extended oil supply shock. Conclusions Mr. X: This is a good place to conclude our discussion. We have covered a lot of ground but I remain deeply concerned that staying invested in risk assets today is akin to picking-up pennies in front of a steamroller. I accept your opinion that a recession is unlikely in 2020, but valuations of both stocks and bonds are uncomfortably stretched for my taste. As a result, I believe stocks could suffer whether growth is good or bad next year. Finally, since so many things need to go right for the global economy to continue to defy gravity, a recession may hit faster than you envision. To me, there is simply not enough margin of safety in stocks to compensate me for the risk! Ms. X: I agree with my father that the risks are high because we are entering the end game of the cycle. But I also see pockets of value, some of which you have mentioned today. Moreover, I am sympathetic to your view that global growth will recover next year. Corporate earnings should therefore expand. Hence, I fear that being out of the market will be very painful, especially because policy is quite accommodative. While stocks may not perform as well as they did in 2019, I expect them to outperform bonds handily. I’m therefore willing to continue holding risk assets, even if I need to be more judicious in my sector and regional allocation. BCA: Your family debate mirrors our own internal discussions. There is always a trade-off between maximizing short-term returns and taking a longer-term approach. Valuations are the ultimate guidepost for long-term return prospects. Because so many assets have become more expensive this year, long-term returns are likely to be uninspiring compared to recent history. Table 6 shows our baseline calculations of what a balanced portfolio will earn over the coming decade. We estimate that such a portfolio will deliver average annual returns of 4.4% over the next ten years, or 2.4% after adjusting for inflation. That is a noticeable deterioration from our inflation-adjusted estimate of 2.8% from last year, and also still well below the 6.5% real return that a balanced portfolio earned between 1982 and 2019. Table 6Asset Market Return Projections Our outlook for next year hinges on global growth rebounding and policy uncertainty receding. Monetary policy is less of a threat to equities than it was last year because central banks have already eased considerably and have been very open about their willingness to let inflation run above target for a while before retightening the monetary screws. We propose the following list of easy-to-track milestones to monitor whether or not our central scenario for the global economy and asset markets is playing out, and how close we are to the end of the cycle: Chinese money and credit numbers. Chinese credit growth must stabilize for the economy to do so. If credit origination continues to decelerate, this will indicate that Beijing has decided to tolerate the slowdown and prioritize its reform and deleveraging agenda. In this case, the Chinese debt supercycle is over sooner and the global economy will pay the price. Our China Investment Strategy Activity Index. Global policy is accommodative and liquidity conditions have improved significantly. However, if the Chinese economy continues to deteriorate, global growth will not rebound. The China Activity Index must stabilize and even improve somewhat for our global growth view to come to fruition. Progress in the “phase one” deal. China and the US must agree to a trade détente. As long as uncertainty around immediate tariffs remain high and retaliation risks stay alive, global capital spending intentions and thus the global manufacturing sector will be hamstrung. Surveys of global growth. The Global manufacturing PMI and the global growth expectation component of the ZEW survey must both recover. If these variables cannot gain any traction, the global economy is sicker than we estimate and risk assets will suffer. Commodity prices and the dollar. In the first quarter, industrial commodity prices must rebound and the dollar must start to depreciate. These two developments will not only reflect an improvement in global growth. They will also alleviate deflationary pressures around the world, revive profits and sponsor a business spending recovery. Moreover, a weaker dollar will also ease global financial conditions by decreasing the global cost of capital. 10-year inflation breakeven rate. If US breakevens move above the 2.3% to 2.5% zone, the Fed will become more proactive about raising rates. This would provoke a quicker end to the business cycle. President Trump’s approval rating. If President Trump’s approval rating stabilizes below 42%, he could give up on the economy and instead bet on a “rally around the flag” as his best strategy for re-election. This would result in a much more hawkish and confrontational White House that would become an even greater source of uncertainty for the economy, and thus risk asset prices. Ms. X: Thank you for this comprehensive list of variables to monitor. As always, you have left us with much to think about. We look forward to these discussions every year. Before we conclude, it would be helpful to have a recap of your key views. BCA: It will be our pleasure. The key points are as follow: Global equities are entering the end game of their nearly 11-year bull market. Stocks are expensive, but bonds are even more so. As a result, if global growth can recover and the US can avoid a recession in 2020, earnings will not weaken significantly and stocks will again outperform bonds. Low rates reflect the end of the debt supercycle in the advanced economies. However, the debt supercycle is still alive in EM in general, and in China, in particular. The global economic slowdown that begun more than 18 months ago started when China tried to limit debt growth. If Beijing continues to push for more deleveraging, global growth will continue to suffer as the EM debt supercycle will end. Nonetheless, we expect China to try to mitigate domestic deflationary pressures in 2020. As a result, a small wave of Chinese reflation, coupled with the substantial easing in global monetary and liquidity conditions should promote a worldwide re-acceleration in economic activity. Policy uncertainty will recede next year. Domestic constraints are forcing China and the US toward a trade détente. The risk of a no-deal Brexit is now marginal, and President Trump is still the favorite in 2020. A decline in policy risk will foster a global economic rebound. That being said, some pockets of risk remain, such as in the Middle East. Global central banks are highly unlikely to remove the punch bowl anytime soon. Not only will it take some time before global deflationary forces recede, monetary authorities in the G10 want to avoid the Japanification of their economies. As a result, they are already announcing that they will allow inflation to overshoot their 2% target for a period of time. This will ultimately raise the need for higher rates in 2021, which will push the global economy into recession in late 2021, or early 2022. These dynamics are key to our categorization of 2020 as the end game. US growth will re-accelerate. The US consumer remains in good shape thanks to healthy balance sheets and robust employment and wage growth prospects. Meanwhile, corporate profits and capex should benefit from a decline in global uncertainty and a pick-up in global economic activity. China will continue to stimulate its economy but will not do so as aggressively as it did over the past 10 years. Consequently, EM growth will also bottom but is unlikely to boom. Europe and Japan will re-accelerate in 2020. Bond yields will grind higher in 2020. However, Treasury yields are unlikely to break above the 2.25% to 2.5% range until much later in the year. Inflationary pressures won’t resurface quickly, so the Fed is unlikely to signal its intention to raise interest rates until late 2020 or later. European bonds are particularly unattractive. Corporate bonds are a mixed offering. Investment grade credit is unattractive owing to low option-adjusted spreads and high duration, especially when corporate health is deteriorating. Agency mortgage-backed securities and high-yield bonds offer better risk-adjusted value. Global stocks will enjoy their last-gasp rally in 2020. As global growth recovers, favor the more cyclical sectors and regions which also happen to offer the best value. US stocks are the least attractive bourse; they are very expensive and loaded with defensive and tech-related exposure, two groups that could suffer from higher bond yields. We are neutral on EM equities. Investors should pare exposure to equities after inflation breakevens have moved back into their 2.3% to 2.5% normal range and the Fed funds rate has moved closer to neutral. We anticipate this to be a risk in 2021. The dollar is likely to decline because it is a countercyclical currency. Balance of payment dynamics and valuation considerations are also becoming headwinds. The pro-cyclical European currencies and the euro should be the main beneficiary of any dollar depreciation. Oil and gold will have upside next year. Crude will benefit from both supply-side discipline and a recovery in oil demand on the back of the improving growth outlook. Gold will strengthen as global central banks limit the upside to real rates by allowing inflation to run a bit hot. A weaker dollar will flatter both commodities. A balanced portfolio is likely to generate average returns of only 2.4% a year in real terms over the next decade. This compares to average returns of around 6.5% a year between 1982 and 2019. We would like to take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 22, 2019

Special Report

Feature Chart 1A Feeling Of Deja Vu? Chair Powell described the recent rate cut as a “mid-cycle adjustment,” rather than a transition to full-on policy easing. This mid-cycle reference was most likely intended to leave the door open for (i) additional “insurance cuts”, likely as soon as September,1 and (ii) the tightening cycle that began at the end of 2015 to eventually resume. Needless to say the market – and President Trump –did not appreciate the hawkish tone of the latter. Importantly, it shows that the current cycle is very similar to the one in the mid-90s (Chart 1). Back then, following the post-Mexican peso devaluation (Tequila Crisis) in December 1994, the bond market started pricing three Fed cuts while the stock market was rebounding in Q1/1995 from the previous quarter’s drawdown (Chart 1, panel 2). Further, the Fed rate cuts in the mid-90s came in response to persistently low and weakening U.S. inflation (Chart 1, panel 3) amidst slowing growth in the rest of the world (Chart 1, panel 4). Bear with us, there is more to it. Former President Clinton was up for reelection the year following the first rate cut in July 1995, at a time that would later be painted as one of “irrational exuberance” in financial markets by then-Chairman Alan Greenspan. In other words, the Fed acted to sustain that economic expansion, respond to the deflationary pressures and mitigate international developments. Sound familiar?  Table 1Run-Up To The First Rate Cut: Now Vs. 1995 As a result, we decided to follow-up on the Special Report published in May when we examined which sectors performed best during Fed loosening cycles leading to recessions.2 In this issue, we delve a little deeper and – in light of all the similarities mentioned above – only look at the sectors’ relative performance following “mid-cycle adjustments” in the post-war era or, broadly speaking, the six loosening cycles that did not morph into a recession. We first isolate the 1995 episode, as the similarities in the stock market’s behavior between now and then are uncanny (Table 1). The S&P returned 18.6% and 17.3% in the six months leading to the 1995 and 2019 initial rate cuts, respectively. In relative terms, seven of the 10 sectors actually performed in a similar fashion over these two periods.3 Further, we broaden out our analysis by including six such non-recessionary loosening episodes, as highlighted in Chart 2. We omit the short-lived tightening in monetary policy both in 1976 and 1986 and instead look at the broader loosening trend. Chart 2Post-War Era Mid-Cycle Adjustments Table 2 displays the results of our analysis of the sectors’ relative average performance during “mid-cycle adjustments.” Table 2Sector Relative Performance And Non-Recessionary Fed Rate Cuts The average performance of the broad market registers negative returns ahead of the first rate cut followed by strong 6-, 12- and 24-month positive returns given the more supportive monetary backdrop and the absence of a dreaded recession. What follows in Charts A, B, C and D, is the sectors’ relative performance in the four different timeframes. The rate-sensitive sectors – S&P utilities, telecoms, consumer discretionary and financials – underperform early before they outperform once the Fed has started to ease with the exception of the S&P utilities which initially delivers low but positive returns and continue to underperform up to two years after the beginning of the “mid-cycle adjustments.” Chart 3Defying Gravity Similarly, we find that most of the deep cyclicals underperform in the run-up to the first rate cut and usually outperform subsequently. The S&P energy is an exception as it outperformed heading into the cutting cycle and then underperformed 6 to 12 months after the first rate cut. Admittedly, we cannot yet rule out the possibility Jay Powell and the Fed might very well be wrong and that the July cut will turn out to be more than just a “mid-cycle adjustment.”  After all, various slopes of the yield curve have already inverted (Chart 2, bottom panel) and the probability that the U.S. might enter into a recession 12 months from now reached 31.5% at the end of July, according to the New York Fed probit model based on the 3-month/10-year Treasury slope (Chart 3). Besides, that was before the yield curve underwent a roughly parallel shift lower of about 30 bps in a few days earlier this month, following the FOMC meeting and news about the escalation in Sino-U.S. trade tensions. Chart 3 shows our probit forecast taking into account the recent further yield curve inversion. What we know is that the current loosening episode is likely to run at least for the rest of the year. Market participants still expect at least three additional rate cuts from the Fed over the next 12 months (Chart 1, panel 2) and, as a reminder, the “mid-cycle adjustments” in the past all provided more than one interest rate cut. While we use this Special Report as a roadmap to sector performance before and after a “mid-cycle adjustment,” our view remains that a recession looms in the coming 18 months and, as such, we continue to decrease cyclical sector exposure and to add defensive exposure.4 (For purposes of completeness, we included reference charts in Appendix A showing individual sector relative performance since 1960 with the non-recessionary Fed rate cut episodes highlighted.) Finally, for those interested in how the yield curve reacts to such “mid-cycle adjustments,” our U.S. Bond Strategists5 performed a similar exercise and found that the 10-year Treasury yield has a tendency to rise following non-recessionary rate cuts and decline following rate cuts that led to a U.S. recession. They also document an interesting yield curve pattern: the curve tends to steepen quite sharply in the aftermath of a non-recessionary rate cut, before starting to flatten after a few months. Appendix A  Chart 4A Chart 4B Chart 4C Chart 4D Chart 4E Chart 4F Chart 4G Chart 4H Chart 4I Chart 4J   Jeremie Peloso, Research Analyst JeremieP@bcaresearch.com Arseniy Urazov, Research Associate ArseniyU@bcaresearch.com Footnotes 1 As we go to press, the probability of a 25 bps rate cut for the September FOMC meeting is 74.2% and of 25.8% for a 50 bps rate cut, based on CME FedWatch Tool. 2 Please see U.S. Equity Strategy Special Report, “Sector Performance And Fed Loosening Cycles: A Historical Roadmap”, dated May 6, 2019, available at uses.bcaresearch.com 3 Please see U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment”, dated June 10, 2019, available at uses.bcaresearch.com 4 Please see U.S. Equity Strategy Weekly Report, “The Fed Apotheosis”, dated July 29, 2019, available at uses.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Track Records”, dated June 18, 2019, available at usbs.bcaresearch.com

Dear Client, Next week I am sending you a Special Report on Japan written by Amr Hanafy, Research Associate of BCA’s Global Asset Allocation service. Amr answers some key questions that clients have been asking about Japan recently: Does the Bank of Japan have any monetary policy ammunition left? How hard will October’s tax hike hit consumption? Has Japan’s corporate governance improved meaningfully? Is there a case for a rerating of Japanese equities? I trust you will find his report very informative. Best regards, Peter Berezin, Chief Global Strategist Highlights Risk assets are likely to struggle over the next few weeks as investors digest both the decision by President Trump to further raise tariffs on Chinese imports, and the realization that the Fed’s “insurance cuts” may not be as generous as they had anticipated. Beyond then, the key question is whether the global economy is, in fact, experiencing a mid-cycle slowdown or is on the brink of a recession. If it is the former, as we think is the case, risk assets will bounce back. Despite the bluster from the Trump Administration, a trade deal between the U.S. and China is still more likely than not. The failure to reach a deal would weaken the U.S. economy, hurting Trump’s reelection prospects. Reassuringly, there is scant evidence that the global manufacturing downturn has infected the service sector to any significant degree. This is true not just for the U.S., but for manufacturing-intensive economies such as Germany as well. The share of manufacturing in both GDP and employment has fallen steadily around the world. Manufacturing output has also become less volatile over time, and less correlated with service sector growth. As global manufacturing activity starts to recover later this year, earnings growth will pick up. Stay overweight global equities relative to bonds on a 12-month horizon, while preparing to increase exposure to EM and European stocks. Feature First The Fed, And Then Trump Risk assets got hit by a one-two punch this week. First, the Federal Reserve dashed investors’ hopes for an extended easing cycle. While the Fed did cut rates by 25 basis points and pledged to end its balance sheet runoff in August (two months earlier than previously indicated), Jay Powell’s characterization of the Fed’s current mantra as a “mid-cycle adjustment to policy” suggested that further cuts were far from guaranteed. To reinforce the point, Powell stated that the Fed was not at “the beginning of a lengthy cutting cycle.” “That’s not our perspective now, our outlook,” he added. Contributing to the hawkish backdrop, Esther George, the president of the Kansas City Fed, and Eric Rosengren, the once fairly dovish president of the Boston Fed, voted to keep rates unchanged. Equities initially plunged on Wednesday following Chair Powell’s press conference. Markets rallied back Thursday morning, only to tumble again in the wake of President Trump’s decision to further raise tariffs on Chinese imports. There is no shortage of theories purporting to explain the timing of Trump’s decision. Was he trying to send a message to the Fed that it had better keep easing? Was he annoyed that Elizabeth Warren, Bernie Sanders, and a number of other presidential contenders tried to outflank him on trade during the Democratic debate the prior evening by suggesting he was not protectionist enough? Regardless, risk assets are likely to struggle over the next few weeks as investors grapple with both renewed trade war anxiety and the realization that the Fed’s “insurance cuts” may not be as generous as they had anticipated. Beyond then, the key question is whether the global economy is, in fact, experiencing a mid-cycle slowdown or is on the brink of a recession. If it is the former, as we think is the case, risk assets will bounce back. While a severe escalation of the trade war would tip the scales towards recession, the risk of such an outcome remains low. Negotiations with China are ongoing. The threat to further raise tariffs in September is consistent with the “maximum pressure” doctrine that has governed Trump’s policy decisions. Ultimately, the failure to reach a trade deal would weaken the U.S. economy, undermining Trump’s reelection prospects. The fact that the latest tranche of tariffs, unlike previous ones, will fall mainly on consumer goods could further hurt Trump in the polls. He does not want that. The Manufacturing Cycle: How Low Will It Go? Chart 1The Global Manufacturing Cycle Has Likely Reached A Bottom Trade tensions have undoubtedly exacerbated the global manufacturing downturn. However, trade policy hasn't been the only culprit, as evidenced by the fact that manufacturing activity began to decelerate even before the trade war heated up in earnest. As we explained in detail last week,1 manufacturing activity tends to follow a “natural cycle” lasting about three years, with output growth rising for the first 18 months, and falling for the next 18 months (Chart 1). The latest downleg began at the start of 2018. Thus, as long as the trade war does not spiral out of control, we should soon see a bottom in the manufacturing cycle based on this timing. For now, the evidence for such a bottom remains mixed. It is encouraging that data released this week showed an improvement in the Chinese Caixin Manufacturing PMI and a slight uptick in the new orders component of the U.S. ISM manufacturing survey. Nevertheless, both surveys remain weak in absolute terms. Meanwhile, the European PMIs have continued to deteriorate, taking the global manufacturing PMI down to 49.3 in July, the lowest level since October 2012.  What one can say more definitively is that at least so far, the manufacturing downturn has not infected the service sector to any significant degree (Chart 2). The U.S. non-manufacturing ISM will be released on Monday, but the June reading of 55.1, while below year-ago levels, was still in the middle of its historic range (Chart 3). Chart 2AThe Service Sector Has Softened Much Less Than Manufacturing (I) Chart 2BThe Service Sector Has Softened Much Less Than Manufacturing (II)   Chart 3U.S. ISM Non-Manufacturing Still Close To Its Historic Average Strong demand for services has underpinned U.S. employment growth which, in turn, has supported consumption growth. Real PCE rose by 4.3% in Q2. The jump in the Conference Board’s index of consumer confidence in July suggests that U.S. consumers remain upbeat. Notably, the services PMI has increased in the euro area this year, even as the manufacturing sector has weakened there. In Germany, where the manufacturing PMI plunged to 43.2 in July, the non-manufacturing PMI still managed to clock in at 55.4, up from 51.8 in December 2018. Manufacturing: A Canary In The Coal Mine Or Just A Coal Mine? The fact that the overall German economy has not come crashing down despite its high reliance on manufacturing is reassuring. Nevertheless, many investors remain convinced that it is just a matter of time before manufacturing woes precipitate a broad-based economic downturn. Such concerns are well founded if protectionism causes the entire global trading system to come crashing down. However, provided that this does not occur, it is unlikely that slower manufacturing growth, in and of itself, will trigger a recession. Uncertainty over Fed policy and the trade war are likely to weigh on risk assets over the coming weeks. Contrary to conventional wisdom, there is little evidence that manufacturing leads the broader economy. Chart 4 clearly shows that manufacturing output tracks overall real GDP growth, with no clear lead-lag relationship. Chart 4Manufacturing Activity Moves In Sync With The Broad Economy Granted, manufacturing growth is more volatile than GDP growth, but that is simply because of the nature of manufacturing production. More than half of manufacturing output consists of durable goods. Purchases of durable goods tend to be lumpy over time. When unemployment starts to rise, households typically postpone purchases of, say, refrigerators and automobiles, while businesses postpone purchases of capital goods. As inventories pile up, manufacturers respond by cutting output. The opposite happens during expansions. The Declining Role Of Manufacturing In The Economy As a share of GDP, global manufacturing output currently stands at 16%. The manufacturing share has been trending lower in most countries (Chart 5). In the U.S., where the data goes back much further, manufacturing output has declined from over 25% of GDP in the 1950s to 11% of GDP at present. The share of manufacturing jobs in total employment has dropped in tandem (Chart 6). Chart 5The Declining Role Of Manufacturing Is A Global Phenomenon Chart 6The Relative Size Of Manufacturing In The U.S. Economy Has Been Falling   The volatility of manufacturing growth rates has also fallen over time. This has occurred partly because of better inventory management techniques. Chart 7 shows that the ratio of real nonfarm inventories-to-domestic sales of goods and structures has been trending lower for the past 40 years. Diminished fears of oil embargos and price controls, which were rampant during the 1970s, have also allowed inventory levels to come down. Chart 7A Structural Decline In The Inventories-To-Sales Ratio Starting In The Early 1980s As manufacturing has become a smaller and less volatile part of the economy, its impact on the service sector has diminished. In fact, we estimate that all of the reduction in the variance of U.S. private sector GDP growth over the past 50 years can be attributed to a smaller contribution from the goods-producing sector, as well as a decline in the correlation between goods-producing and service-producing industries (Chart 8). Investment Conclusions Uncertainty over Fed policy and the trade war are likely to weigh on risk assets over the coming weeks. As long as the trade war does not boil over, global manufacturing activity should recover during the remainder of this year, boosting corporate earnings in the process. More cyclically-oriented stock markets and sectors will benefit the most. Non-U.S. stocks have the advantage of trading at a substantial discount to their U.S. peers. Chart 9 shows that U.S. stocks trade at 17.5-times forward earnings, while non-U.S. stocks trade at only 13.5-times forward earnings. We expect to upgrade European and EM equities over the coming months. Chart 9AEquities: Better Valuations Outside The U.S. (I) Chart 9BEquities: Better Valuations Outside The U.S. (II) Better global growth prospects should cause the dollar to weaken. Stronger growth should also allow government bond yields to rise and yield curves to steepen. Investors should favor stocks over bonds for the next 12 months. Housekeeping: We were stopped out of our long EUR/JPY trade for a loss of 5%. We will consider reopening this trade once market volatility settles down.   Peter Berezin, Chief Global Strategist Global Investment Strategy  peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “Three Cycles,” dated July 26, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Highlights The global manufacturing cycle has averaged about three years in length (peak-to-peak). We are near the bottom of the current cycle, which should set the stage for a recovery phase lasting around 18 months. The global economy will start to slow in 2021, culminating in a recession in 2022. The long-term global disinflationary cycle is drawing to a close. Investors should remain bullish on risk assets for the next two years, but expect subpar returns over a longer-term horizon.  Feature The Wheels Are Turning BCA Research has a long and proud history of analyzing economic and financial market cycles. Three types of cycles, in particular, have proven to be important to investors: Short-term manufacturing cycles lasting roughly three years. Medium-term business cycles affecting the entire economy. Long-term supercycles that can span decades. These often involve significant economic, social and political changes. What Really Caused The Global Manufacturing Downturn? The latest global manufacturing downturn has been widely attributed to the escalation of the trade war, the Chinese deleveraging campaign, and the end of the “sugar rush” from the Trump tax cuts. We have no doubt that all these factors exacerbated the downturn. However, it is not clear whether they caused it. As Chart 1 illustrates, the Chinese deleveraging campaign began in late 2016, more than a year before the global manufacturing sector peaked. The trade war only heated up in the spring of last year, after manufacturing activity had already begun to roll over. The jury is still out on the extent to which U.S. corporate tax cuts spurred capital spending, as opposed to being funnelled into retained earnings and share buybacks. Regardless, the fact that capex has weakened less in the U.S. than abroad over the past 18 months suggests that the fading impact from U.S. tax cuts was not the main culprit (Chart 2). Chart 1Chinese Credit Growth Deceleration Preceded The Global Manufacturing Slowdown Chart 2The Capex Slowdown Has Been Less Severe In The U.S.   A Predictable Cycle Chart 3The Global Manufacturing Cycle Has Likely Reached A Bottom Lost in the discussion over the cause of the slowdown is that global manufacturing activity follows a fairly predictable three-year growth cycle: up for the first 18 months, down for the second 18 months (Chart 3). This is not an immutable law of nature, but it is a handy rule of thumb. The last growth cycle began in the late spring of 2016 and reached a crescendo in December 2017 (based on the global manufacturing PMI). For now, the global manufacturing sector remains in the doldrums, with this week’s worse-than-expected Markit PMI readings for both the U.S. and the euro area being prime examples. However, if history is any guide, activity should begin to rebound over the coming months. Global manufacturing activity follows a fairly predictable three-year growth cycle. The large improvement in the Philly Fed manufacturing PMI – arguably the most important of all the regional Fed manufacturing surveys1 – in July, strong U.S. core capital goods orders, as well as the slight uptick in Korean exports on a month-over-month basis, are positive signs in that regard. The same goes for the sales outlook of two manufacturing bellwether companies which reported earnings this week: United Technologies and Texas Instruments. The former manufactures Otis elevators, Carrier air conditioning/HVAC, and Pratt & Whitney jet engines. The latter’s components are widely used throughout the global semiconductor industry. Chart 4 shows that the semiconductor cycle closely tracks the overall manufacturing cycle. Chart 4Semiconductor And Manufacturing Cycles Tend To Overlap Cycles And Feedback Loops What drives the short-term manufacturing cycle? The answer is the same thing that drives all cycles: The existence of self-limiting feedback loops. In the case of the manufacturing cycle, the feedback loop is fairly straightforward to describe. A pickup in manufacturing sales boosts profits and creates new jobs. This causes consumer and business confidence to rise. Improving confidence leads to more sales, which generates even higher confidence. If that were all there was to the story, this virtuous cycle would never end. This is where the “self-limiting” part comes in. Most manufactured goods are durable goods, meaning that they retain value for some time after they are purchased. When spending on, say, automobiles or computers rises to a high level for an extended period of time, a glut will form, requiring a period of lower production. This, in turn, will generate a negative feedback loop where falling sales lead to lower confidence and so forth. The glut will eventually shrink. Once enough pent-up demand has accumulated, a new upcycle will begin.  The Role Of Finance Banks and other financial institutions play a critical role in both perpetuating, and ultimately short-circuiting, the feedback loop described above. Business lending tends to ebb and flow with capital spending (Chart 5). It is not so much that one causes the other. It is better to think of the two as locked in a self-reinforcing tango: Faster output growth leads to more lending, and more lending leads to faster output growth. Chart 5The Ebb And Flow Of Lending And Capex Go Hand In Hand The amount of time it takes for the music to end, and for the dancers to part ways, varies from episode to episode. If both lenders and borrowers are feeling skittish, the party may never reach a fever pitch. While that may sound like a bad thing, it has the redeeming feature that imbalances never get a chance to reach critical levels. This brings us to today: Unlike in the pre-financial crisis period, when banks held Chuck Prince’s view that “as long as the music is playing, you’ve got to get up and dance,” lenders are more circumspect. This is a critical reason why we think the next U.S. recession is not imminent. Private-Sector Imbalances Remain Low In The United States Despite this being the longest U.S. expansion on record, the ratio of private debt-to-GDP is still well below where it was at the start of the decade (Chart 6). Chart 6U.S. Private Sector Leverage Remains Below Its Previous Peak Granted, corporate debt levels have scaled new highs. However, thanks to low interest rates, interest coverage ratios remain above their post-1980 average. This is true for the economy as a whole, as well as for the broad equity market (Chart 7). Chart 7AInterest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (I) Chart 7BInterest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (II) Spending on business equipment, new homes, and consumer durables also remains restrained. This explains why the average age of the U.S. capital stock has increased sharply since the Great Recession (Chart 8). Chart 8The Capital Stock Is Aging Public-Sector Imbalances On The Rise, But Not Yet At Critical Levels Chart 9The Private Sector Is Not Living Beyond Its Means The Way It Was Before The Last Two Recessions The one area where clear imbalances in the U.S. are present is in public finances. The tentative deal between the Trump Administration and Congress to raise spending caps and increase the debt ceiling ensures that fiscal policy will stay accommodative for the foreseeable future. Unfortunately, the cost of this fiscal largesse is a budget deficit that is set to swell to $1 trillion (4.5% of GDP) in FY2020, up from $586 billion (3.2% of GDP) in FY2016. Financing this deficit over the next few years is unlikely to pose serious challenges because the private sector remains an ample source of savings (Chart 9). However, once this reservoir of savings starts to recede, bond yields could rise sharply.   Chinese Imbalances: How Much Of A Concern? Economic and financial imbalances are more pronounced abroad. In China, fixed investment spending has averaged 44% of GDP over the past decade. Debt levels have soared over this period. That said, much of this debt-financed investment should be regarded as a form of stimulus for an economy that suffers from a chronic shortfall of consumption. So far this year, the decline in Chinese private-sector fixed-asset investment has been counterbalanced by an increase in infrastructure spending (Chart 10). As in the U.S. and many other economies, abundant Chinese savings have allowed interest rates to stay low, thereby ensuring that borrowers are able to tap credit at favorable terms. We expect the Chinese authorities to continue stimulating their economy. Unlike in early 2017, credit growth is only modestly above trend nominal GDP growth (Chart 11). In addition, a stronger economy would give the Chinese government more leverage over trade negotiations. Chart 10China: Declining Private-Sector Investment Counterbalanced By Increasing Infrastructure Spending Chart 11China: The Deleveraging Campaign Has Been Put On The Backburner   A Turn In The Long-Term Inflationary Cycle? While the unemployment rate has returned to pre-recession levels in many economies, the scars from the Great Recession still remain. Nowhere is this more manifest than in the hypersensitivity that central banks have displayed towards bad economic news. Just as central bankers in the 1960s were fixated on avoiding the mass unemployment that accompanied the Great Depression, today’s central bankers are laser-focused on propping up demand at all costs. The new conventional wisdom is that the Phillips curve is dead. Chart 12 casts doubt on this assertion: It shows that the relationship between wage growth and various measures of labor market slack still seems very much alive and well. Chart 12A Tighter U.S. Labor Market Has Been Translating Into Stronger Wage Growth... Chart 13...But No Imminent Threat Of A Wage-Price Inflationary Spiral Admittedly, faster wage growth has failed to push up inflation. However, this may be simply because productivity growth has sped up. In the U.S., unit labor cost inflation has actually decelerated sharply since late 2017 (Chart 13). If wage growth continues to grind higher, firms will have no choice but to start raising prices. This could set the stage for an upleg in the longer-term inflationary cycle.   Structural Forces: Not So Deflationary Anymore Once inflation starts to move higher, a number of structural forces could help it along. The period of hyperglobalization, which began with the collapse of the Soviet Union and the integration of China into the global economy, is over. The ratio of global trade-to-GDP has been flat for over a decade (Chart 14).  Chart 14Globalization Has Peaked Demographic trends are shifting from deflationary to inflationary. Now that baby boomers are starting to retire, they will begin running down their savings. Chart 15 shows that ratio of workers-to-consumers globally has begun to fall after a four-decade ascent. Chart 15The Worker-To-Consumer Ratio Has Started Shrinking Globally As more people retire, aggregate savings will fall. The shortage of savings will put upward pressure on the neutral rate of interest. If central banks drag their feet in raising policy rates in response to an increase in the neutral rate, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up. The political winds are also blowing in the direction of higher inflation. Populism is on the rise. Whether it be right-wing populism or left-wing populism, the result is usually bloated budget deficits, compromised central bank independence, and productivity-reducing policies. Stagflation may once again rear its head. Investment Conclusions The path to higher interest rates is paved with lower rates, meaning that the longer a central bank keeps rates below their neutral level, the more economies will overheat, and the larger the eventual inflation overshoot will be. We expect the Fed to cut rates by 25 basis points next week, with another cut possible in September. The ECB and most other central banks are also in easing mode. The good news is that inflation is a notoriously lagging indicator (Chart 16). It will probably take at least a year for clear evidence of overheating to emerge in the U.S., and even longer abroad. The bad news is that once inflation breaks out, it could do so quite dramatically. The market is not prepared for this (Chart 17).     Investors should maintain a bullish stance towards risk assets for the next 12-to-18 months, before starting to scale back exposure. Not only are central banks becoming more dovish, but the global manufacturing cycle is about to turn up. Stronger global growth will lead to a weaker U.S. dollar (Chart 18). EM and European stocks will start to outperform U.S. stocks (Chart 19). Cyclicals will trump defensives. Chart 18The Dollar Is A Countercyclical Currency Chart 19EM And Euro Area Equities Outperform When Global Growth Improves     As global yield curves steepen anew, bank stocks will power higher. U.S. small caps, with their relatively high weighting in regional banks, will outperform their large cap brethren (Chart 20). Chart 20Big Has Crushed Small   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1    The manufacturing segment in the region covered by the Philadelphia Fed is representative of the national manufacturing sector and hence tracks the ISM manufacturing index better than the other regional Fed surveys. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Highlights The EM equity and currency rebounds should be faded. When corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. This is the case in EM and China. Our leading indicators for the Chinese business cycle continue to point to intensifying profit contraction in both China and EM. The ratio of global broad money supply to the current value of securities worldwide is at an all-time low. This casts doubt on the “too much money chasing too few assets” hypothesis. Feature Chart I-1EM Share Prices: Decision Time EM share prices are at a critical juncture (Chart I-1). Their ability to hold their recent lows and break above their April highs will signify that a sustainable cyclical rally is in the making. Failure to punch through April’s highs will pose a major breakdown risk. In brief, EM is facing a make-it-or-break-it moment. Fundamentally, the outlook for EM risk assets and currencies largely hinges on economic growth in general and corporate profits in particular. In our June 20 report, we illustrated that the primary drivers of EM risk assets and currencies have historically been their business cycles and profit growth – not U.S. interest rates. Falling interest rates are positive for share prices when profits are expanding, even if at a slower rate. However, when corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. Hence, lower global interest rates in of themselves are not a sufficient condition to foster a sustainable cyclical EM rally. As to EM corporate profits, the rate of their contraction will continue deepening. Since early this year, we have been arguing that expectations of recovery in the Chinese economy and global trade are unwarranted. That is why BCA’s Emerging Markets Strategy team contends that EM risk assets and currencies, as well as China-plays, face the risk of a breakdown. This differs from BCA’s house view, which is positive on global risk assets in general. Global And Chinese Business Cycles: No Recovery So Far Chart I-2Chinese A-Share EPS Is Heading Into Contraction The rebound in EM risk assets and currencies since last December has occurred despite no improvement in both China’s business cycle and global trade, and despite the deepening contraction in EM corporate profits. Since early this year, we have been arguing that expectations of recovery in the Chinese economy and global trade are unwarranted. So far, our baseline economic view has played out – mainland growth has been rather weak, and global trade has contracted. Yet EM financial markets have done better than we had anticipated. China’s domestic industrial new orders lead Chinese A-share earnings per share growth rate by about nine months and point to intensifying profit slump into early 2020 (Chart I-2). Furthermore, China’s adjusted narrow money(M1+)1 growth leads Chinese investable stocks earnings per share (EPS) by about nine months, and is also pointing to further compression (Chart I-3). Finally, Korea’s exports are shrinking, as are EM EPS (Chart I-4, top panel). Chart I-3Chinese Investable Companies' EPS Is Already Shrinking Chart I-4Korean Exports And EM EPS   Notably, both Korean exports values and EM EPS in U.S. dollars terms are on par with their early  2011 levels (Chart I-4, bottom panel). This indicates that neither Korean exports nor EM EPS have expanded sustainably over the past eight years. Chart I-5Global Stocks Did Not Lead Global PMI Historically Is it possible that the current gap between global share prices and global manufacturing is due to the fact that financial markets are forward-looking and lead business cycles? Historical evidence suggests that global share prices have not led the global manufacturing PMI, as exhibited in Chart I-5. In fact, global share prices have actually been coincident with the global manufacturing PMI not only throughout this decade but before that as well. The de-coupling between share prices and the manufacturing PMI is currently also present in EM, albeit in a less-striking form. Chart I-6 illustrates that the EM manufacturing PMI has slipped below 50 line, yet share prices have recently rebounded and sovereign spreads have tightened. In a nutshell, the divergence between global share prices and the global manufacturing PMI is unprecedented. This cannot be explained by falling global bond yields either. The latter were falling in the previous business cycle downtrends (2011-12 and 2015), yet share prices did not deviate from the global manufacturing PMI during those episodes (Chart I-5). Chart I-6EM PMI And EM Risk Assets Chart I-7The Rest Of World's Exports To China Will Continue Shrinking It seems that the global equity and credit markets expect an imminent recovery in the global business cycle in general and in China in particular. As we elaborated in the previous reports, the current global manufacturing recession stems primarily from China. Our leading indicators of the mainland business cycle suggest that more growth disappointments are likely before China’s growth and other economies’ shipments to the mainland hits a bottom (Chart I-7). For example, Korea’s exports to China in June were still dropping by 24% from a year ago. The primary reason for the lack of revival in growth is that China’s stimulus efforts have so far not been large enough, and the marginal propensity to spend among households and companies is diminishing, offsetting the positive effect of the stimulus, as we have discussed in previous reports. Will the recent G20 trade truce between the U.S. and China boost business confidence worldwide and in China? In our view, it is unlikely to produce a quick and meaningful recovery in business confidence among multinational companies and Chinese businesses. Corporate managers have probably come to realize that the U.S.-China row is not about import tariffs but rather geopolitical confrontation between the existing hegemon and a rising superpower. Hence, there is no easy solution that will satisfy both parties. An acceptable resolution for China will be unacceptable for the U.S., and vice versa. Hence, it will be hard to find a formula that gratifies both sides politically and economically. Overall, we reckon there are low odds in the next six months of an agreement between the U.S. and China that removes tariffs, addresses structural issues and satiates both nations. Korea’s exports are shrinking, as are EM EPS. Finally, even though the S&P 500 is hovering around its previous highs, under-the-surface dynamics have been less upbeat. Specifically, the equal-weighted share price index of U.S. high-beta stocks in cyclical sectors such as industrials, technology and consumer discretionary versus the S&P 500 has been tame and has not yet broken above its 200-day moving average (Chart I-8, top panel). The same holds true for the relative performance of an equal-weighted stock index of global cyclical sectors such as industrials, materials and semiconductors against the overall global equity benchmark (Chart I-8, bottom panel). Conversely, despite its recent setback, the U.S. dollar has technically not yet broken down (Chart I-9, top panel). In fact, our composite momentum indicator for the broad trade-weighted dollar has troughed at zero – a sign that downside is limited and another up-leg will likely emerge soon (Chart I-9, bottom panel). Chart I-8Cyclical Stocks Have Been Underperforming Chart I-9The U.S. Dollar Has Technically Not Broken Down   Bottom Line: The EM equity and currency rebounds should be faded. As EM currencies depreciate, sovereign and corporate credit spreads will likely widen. Asset allocators should continue underweighting EM equities and credit markets relative to their DM peers. Too Much Money Chasing Too Few Assets? Many investors identify “liquidity” as the main reason why global equity and credit markets have done so well this year, despite the relapsing global business cycle. Yet there are as many definitions of “liquidity” as there are investors. Many commentators use the term “liquidity” to denote balance sheet expansion by global central banks. As part of their quantitative easing programs, central banks in the U.S., U.K., Japan, the euro area, Switzerland and Sweden have expanded their balance sheets enormously. In line with their asset expansion, their liabilities – the monetary base, consisting primarily of commercial banks’ excess reserves – have also mushroomed. Nevertheless, broad money supply has grown only modestly in these economies.2 The principal reason behind this phenomenon has been a collapse in the money multiplier due to both banks’ unwillingness to boost lending proportionally to their swelling excess reserves, and a persistent lack of demand for credit among households and businesses. This computation casts doubt on the “too much money chasing too few assets” hypothesis. Broad money supply includes all types of deposits at commercial banks and cash in circulation. Crucially, it does not include commercial banks’ excess reserves at central banks. This differentiation between broad money and excess reserves at central banks is vital because excess reserves are not used to purchase goods, services or assets/securities. Hence, a true measure of purchasing power for assets, goods and services is broad money supply. Consistently, the pertinent liquidity ratio for financial markets can be computed by dividing global broad money supply by the value of all securities outstanding excluding those owned by central banks. The top panel of Chart I-10 depicts the ratio of the sum of broad money supply in 12 economies3 - excluding China - to the market value of investable global equities and bonds. The latter is calculated as the market cap of the Datastream World Equity Index plus the market value of the Barclays Aggregate Bond Index, excluding securities owned by central banks (Chart I-11). Bonds include both government and corporate issues. Chart I-10Comparing Global Broad Money And Market Value Of Outstanding Securities Chart I-11Broad Money, Securities Absorbed By QEs And Value Of Outstanding Securities   We exclude China from this calculation because its money supply (deposits) is not internationally “mobile” – i.e., due to capital controls, Chinese residents cannot convert their renminbi deposits to other currencies, or use them to purchase international securities. Likewise, we exclude Chinese on-shore equity and bond markets from the calculation because they are not easily accessible to all foreign investors. This broad money supply-to-asset values ratio can be regarded as a rough proxy for available liquidity for financial markets.4 Our interpretation is that a lower ratio means investors have lower cash balances relative to the value of financial assets they hold, and vice versa. Interestingly, the ratio of global broad money to the current value of securities worldwide is at an all-time low (Chart I-10, top panel). Hence, this computation casts doubt on the “too much money chasing too few assets” hypothesis. By flipping this ratio, we compute the ratio of market value of all investable securities (excluding the ones owned by central banks) to broad money supply (Chart I-10, bottom panel). It is at all-time high entailing that the market value of globally investable publically-traded securities has expanded much more than global broad money supply/deposits. Bottom Line: We recognize that this is a simplistic macro exercise, and a more comprehensive methodology is required to compute global cash balances that are available to purchase securities worldwide. However, at minimum the above casts doubt on the hypothesis that “too much money is chasing too few assets”. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1      M1+ is calculated as M1 plus household demand deposits and deposits at third-party payment platforms. 2      Note that when a central bank purchases securities from commercial banks, this operation originates excess reserves, but not a new deposit at commercial banks. However, when a central bank acquires securities from a non-bank entity, such as a pension fund or an insurance company, this transaction creates both excess reserves and a bank deposit that did not exist before. Hence, QE programs have created some deposits but less so than excess reserves. 3      Economies included into this aggregate are the U.S., the euro area, the UK, Japan, Canada, Australia, Switzerland, Sweden, Korea, Taiwan, Hong Kong and Singapore. 4      This calculation does not strip out transactional demand for money, i.e., how much money is required to finance regular  economic activity. Given transactional demand for money is not stable, it is hard to estimate and adjust for it.   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Analysis on Thailand is available below. Feature Last week we were on the road meeting with some of our U.S. clients. This week’s report presents some of the key topics of our discussions in a Q&A format. Question: You have been downplaying the potentially positive impact of lower bond yields in advanced economies on EM risk assets. Why do you think lower bond yields in developed markets (DM) and potential rate cuts by DM central banks won’t suffice to lift EM markets on a sustainable basis? Answer: Falling interest rates are positive for share prices when profits are growing, even at a slower rate. When corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. Presently, EM and Chinese corporate earnings are shrinking rapidly (Chart I-1). This is the primary reason why we believe DM monetary easing will not help EM share prices much. Furthermore, EM exchange rates follow relative EPS cycles in local currency terms (Chart I-2). In short, EM currencies are driven by relative corporate profitability between EM and the U.S. – not by interest rate differentials. Chart I-1EM & China EPS Are Contracting Chart I-2Relative EPS And Exchange Rate   The contraction in EM and China EPS has not been caused by higher interest rates and slump in DM domestic demand. Rather, the EM/China profit contraction has been due to China’s economic slowdown spilling over to the rest of EM. Crucially, there is no empirical evidence that interest rate cuts and QEs in DM preclude EM selloffs when EM/Chinese growth is slumping. Specifically: Chart I-3A and I-3B illustrate that neither the level of G4 central banks’ assets nor their annual rate of change correlates with EM share prices or EM local bonds’ total returns in U.S. dollar terms. Hence, QEs have not always guaranteed positive returns for EM financial markets. Chart I-3APace Of QE And EM Performance Chart I-3BPace Of QE And EM Performance Chart I-4U.S. Treasury Yields And EM Performance Chart I-4 demonstrates the correlation between U.S. 5-year Treasurys yields on the one hand and EM spot exchange rates, EM sovereign credit spreads and EM share prices on the other. There has been no stable relationship – at times it has been positive, and at other times negative. We are not implying that DM interest rates have no bearing on EM financial markets. Our point is that lower interest rates and QEs in DM do not constitute sufficient conditions for EM financial markets to rally. Even though DM monetary policy has not been the driving force of cyclical fluctuations in EM financial markets, it has had a structural impact. QEs and lower bond yields in DM have prompted an expanded search for yield and have produced substantial compression in risk premia worldwide. For example, Chart I-5 demonstrates that excess returns on EM corporate bonds have historically been correlated with the global manufacturing cycle, but the correlation has diminished in recent years. The widening gap between the two lines is due to investors’ search for yield. Investors have bought and continue to hold securities of “zombie” companies and countries that have low productivity and poor fundamentals. In short, QEs have undermined the efficiency of global capital allocation. This is marginally adverse for productivity in the global economy in the long run. Question: But doesn’t DM monetary policy influence DM demand, which in turn affects EM corporate profits? Answer: DM monetary policy influences DM domestic demand, but there is little correlation between DM domestic demand and EM corporate profits. For example, U.S. import volumes have been growing at a decent pace, yet EM corporate profits have shrunk (Chart I-6). Indeed, robust growth in U.S. imports did not preclude EM EPS contraction in 2012, 2014-‘15 and 2018-‘19, as shown in this chart. Chart I-5Fundamentals Have Become Less Important Due To QE Programs Chart I-6EM EPS And U.S. Imports   Chart I-7 reveals additional evidence of the diminished impact of U.S. growth on Asian exports. Korean, Taiwanese, Japanese and Singaporean exports to the U.S. are growing at 7% rate, while their shipments to China are contracting at an 11% rate from a year ago as of May. As a result, these countries’ overall exports are shrinking because they ship to China considerably more than they do to the U.S. We are not implying that DM interest rates have no bearing on EM financial markets. Our point is that lower interest rates and QEs in DM do not constitute sufficient conditions for EM financial markets to rally. The current global slowdown did not originate in the U.S. or Europe. Rather, it originated in China and has spilt across the world, affecting the economies that sell to China the most. The deceleration in global trade can be tracked to Chinese imports contraction (Chart I-8). Chart I-7Asia's Exports To China And U.S. Chart I-8Chinese Imports And Global Trade   U.S. manufacturing is the least exposed to China, which is the main reason why it was the last shoe to drop in the global manufacturing recession. Question: So, what drives EM business cycles if it is not DM growth and DM interest rates? Chart I-9China's Credit & Fiscal Impulse And EM EPS Answer: The key and dominant driver of EM risk assets – stocks, credit markets and currencies – has been the global trade and EM/China growth cycles. There is a much stronger correlation between EM financial markets and the global business cycle in general, and Chinese imports in particular than with DM interest rates. In turn, Chinese imports are driven by its capital spending cycle. 85% of the mainland’s good imports are composed of industrial goods and devices, machinery, chemicals, various commodities and autos. Only 15% are non-auto consumer goods. Meanwhile, the credit/money cycles drive capital spending. That is why China’s credit and fiscal spending impulse leads EM corporate profits (Chart I-9). This is also why we spend a significant amount of time analyzing and discussing China's credit cycle. Question: Why has the policy stimulus in China not revived growth in its economy and its suppliers around the world? Answer: Our aggregate credit and fiscal spending impulse bottomed in January of this year, but its recovery has so far been timid. In the past, this indicator led China’s business cycle and the global manufacturing PMI by an average of about nine months (Chart I-10, top panel) and EM corporate profits by 12 months (Chart I-9). According to this pattern, the bottom in global manufacturing should occur in August of this year. However, global share prices have not led global manufacturing PMI during this decade; they have instead been coincident (Chart I-10, bottom panel). Hence, there was no historical justification for global share prices to rally since early January - well ahead of a potential bottom in the global manufacturing PMI in August. The current global slowdown did not originate in the U.S. or Europe. Rather, it originated in China and has spilt across the world, affecting the economies that sell to China the most. That said, due to the U.S.-China confrontation and other structural reasons currently prevailing in China – including high levels of indebtedness and more regulatory scrutiny over shadow banking as well as local government debt – a recovery in mainland household and corporate spending is likely to be delayed. Crucially, as we have documented in previous reports, the marginal propensity to spend for consumers and companies continues to fall (Chart I-11). This is the opposite of what occurred in early 2016. Chart I-10Chinese Stimulus, Global Manufacturing And Global Stocks Chart I-11China: What Is Different From 2016   Overall, a revival in China’s growth will likely take longer to unfold and EM risk assets will likely sell off anew before bottoming. Chart I-12Global Slowdown Is Not Yet Over Chart I-13Global Semiconductor Demand Is Shrinking Question: Apart from China’s credit and fiscal spending impulse and marginal propensity to spend among households and companies, what other indicators are you monitoring to gauge a bottom in the global manufacturing cycle? Answer: Among many variables and indicators we continuously monitor, there are a few we have been paying particular attention to: The difference between global narrow (M1) and broad money growth correlates well with global corporate earnings (Chart I-12). The rationale for this indicator is that it is akin to the marginal propensity to spend: When demand deposits (M1) outpace time/savings deposits, it is indicative that households and companies are getting ready to spend on large-ticket items or kick off capital spending, and vice versa. Presently, this narrow-to-broad money growth differential continues to point to lower global growth. Last week we published a report on the global semiconductor industry, arguing that upstream demand for semiconductors is withering as sales of servers, smartphones, PCs and autos are all shrinking globally (Chart I-13). With consumption of these goods contracting, demand for semiconductors remains lackluster, and semiconductor prices are still deflating (Chart I-14). Hence, semiconductor prices can be used as an indicator of final demand dynamics in many important segments of the global economy. China’s Container Freight Index – the price to ship containers – is also currently lackluster, reflecting weak global trade dynamics (Chart I-15, top panel). Chart I-14Semiconductor Prices Are Still Deflating Chart I-15Global Shipments Are Very Weak   In the U.S., both total intermodal carloads and railroad carloads excluding petroleum and coal are tanking, reflecting subsiding growth (Chart I-15, middle and bottom panel). In turn, Chinese imports continue to contract. This is the primary channel in terms of how the Middle Kingdom affects the rest of the world economy. From the rest of the world’s perspective, China is in recession because their shipments to the mainland are shrinking. In China and Taiwan, the seasonally adjusted manufacturing PMI new orders have rolled over after the temporary pick up early this year (Chart I-16). Finally, we are monitoring our Reflation Indicator and Risk-On/Safe-Haven Currency Ratio (Chart I-17). Both are market-based indicators and are very sensitive to global growth conditions – especially to the dynamics in commodities markets – making them very pertinent to EM investors. Chart I-16Manufacturing PMI: New Orders Seasonally-Adjusted Chart I-17Market-Based Indicators   As with any marked price-based signals, both are very volatile. Even though both indicators have rebounded in recent days, only a major trend reversal matters for macro investors. Technically speaking, the profile of both indicators is consistent with a breakdown rather than a breakout. Question: You have highlighted that EM corporate EPS is contracting. How widespread is the profit contraction, and how long will it persist? Answer: EM corporate EPS contraction is widespread across almost all sectors. Chart I-18A and I-18B illustrate EPS growth in U.S. dollar terms for all sectors. EPS growth is negative for most sectors, close to zero for three (technology, financials and materials) and still positive for the energy sector. However, technology, materials and energy EPS are heading into contraction, given the drop in semiconductor, industrial metals and oil prices, respectively. Chart I-18ASynchronized EM EPS Contraction Chart I-18BSynchronized EM EPS Contraction   Consequently, all EM equity sectors will soon be experiencing synchronized profit contraction. EM corporate EPS contraction is widespread across almost all sectors. Our credit and fiscal spending impulse for China leads EM EPS growth by about 12 months, and it currently entails that the profit contraction will continue to deepen all the way through December (Chart I-9 on page 6). It would be surprising if EM share prices stage a major rally amid a hastening decline in corporate EPS (please refer to Chart I-1 on page 1). Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Thailand: A Defensive Play Within EM The Thai parliament has elected to keep the ex-military general Prayuth Chan-ocha as the country’s prime minister. This will instill political stability for now, which is positive for investor confidence. In absolute terms, Thai financial markets are leveraged to global trade and will, therefore, sell off if our negative views on the latter and EM risk assets play out. Chart II-1Thailand's Current Account Is In Surplus Relative to their EM peers, Thai equities, credit, currency and domestic bonds will continue outperforming: The Thai current account balance remains in large surplus, which provides a large cushion for the Thai baht amid the slowdown in global growth (Chart II-1). Critically, Thailand is less exposed to China and is more leveraged to the U.S. and Europe than its EM peers. Thailand’s shipments to China account for 12% of the former’s total exports, while exports to the U.S. and EU together account for 21%. Both U.S. and European imports are holding up better than those of China. Thailand also has the lowest foreign debt obligations (FDO) among EM countries. FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. The country’s current FDOs stand at 8% relative to its exports of goods and services and 12% relative to the central bank’s foreign exchange reserves. The rest of EM countries have much higher ratios. In addition, foreign ownership of local currency bonds is amongst the lowest in the region (18%). As a result, currency depreciation will not trigger major portfolio outflows and a self-reinforcing downtrend in Thai financial markets. Thailand also has the lowest foreign debt obligations (FDO) among EM countries. Chart II-2Thailand: Moderate Growth In Private Consumption Thailand’s private consumption is growing reasonably well (Chart II-2, top panel). Likewise, passenger and commercial vehicle sales are rising and so is household credit (Chart II-2, bottom two panels). The Thailand MSCI index carries a large weight in domestic and defensive stocks such as transportation, utilities, telecommunication, and consumer staples. These sectors will benefit from moderate consumption growth. In fact, Thai equity outperformance versus EM has been justified by its non-financial companies’ EBITDA outpacing that of EM non-financials (Chart II-3). This trend remains intact. Concerning banks, Thailand’s commercial banks suffer from credit excesses, as do many of their EM peers. However, Thai commercial banks have been responsible in terms of recognizing NPLs and have been properly provisioning for them (Chart II-4). This is contrary to many other EM banks. This means that share prices of Thai commercial banks will outperform their EM counterparts. Finally, although the Thai bourse is more expensive than its EM counterparts, relative equity valuation will likely get even more stretched before a major reversal occurs. Given our cautious view on overall EM, we continue to prefer this richly valued and defensive bourse to the more cyclical, albeit cheaper, but fundamentally vulnerable EM peers. Chart II-3Equity Outperformance Has Been Justified By Earnings Chart II-4Thai Commercial Banks Are Well Provisioned Bottom Line: Investors should keep an overweight position in Thai equities, currency, domestic bonds and credit markets. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Footnotes   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Portfolio Strategy The risk/reward tradeoff remains squarely to the downside and we are turning cyclically (3-12 month horizon) cautious on the prospects of the broad equity market. The Presidential cycle, UBER’s IPO, the SPX hitting all-time highs following the initial December 2018 yield curve inversion, and two additional yield curve inversions signal that this time is no different and a recession is likely upon us in the coming 18 months. The re-escalation of the U.S./China trade tussle along with the risk of an antitrust investigation into Apple, waning capital outlays, softening exports and deteriorating operating conditions warn that it does not pay to be overweight the S&P tech hardware storage & peripherals (THS&P) index. Our tech EPS model is flashing red on the back of sinking capex and an appreciating U.S. dollar, deteriorating operating metrics signal that tech margins are under attack and exports are also in a freefall, suggesting that the time is ripe to put the tech sector on downgrade alert. Recent Changes Downgrade the S&P THS&P index to neutral, today. Put the S&P tech sector on downgrade alert. Table 1 Feature The SPX appeared to crack early in the week, but dovish Fed President statements saved the day and stocks recovered smartly to end the week on a high note. Our tactically (0-3 month) cautious equity market stance has served us well and has run its course. We are currently leaning toward a cyclically (3-12 month) cautious stance as a slew of our cyclical indicators have rolled over decisively. At the current juncture the big call to make is on the longevity of the business cycle. Crudely put, can the Fed engineer a soft landing or is the looming easing cycle a precursor of recession (Chart 1)? We side with the latter. Chart 1What’s The Opposite Of Bond Vigilantes? This is U.S. Equity Strategy service’s view. BCA’s house view remains constructive on a cyclical 3-12 month time horizon. As a reminder, the ongoing expansion is officially the longest on record and BCA’s house view also calls for recession in late-2020/early-2021. Stan Druckenmiller once famously said “…you have to visualize the situation 18 months from now, and whatever that is, that's where the price will be, not where it is today." Thus, if BCA’s recession view is accurate then we need to start preparing the portfolio for a recessionary outcome. This week we conduct a simple thought experiment on where and why the SPX will be headed as the economy flirts with recession. But first, we rely on the message from our indicators to guide us in determining if the cycle is nearing an end. Last December parts of the yield curve slope inverted (Chart 2) and our simple insight was that the market almost always peaks following the yield curve inversion and we remained bullish on the prospects of the broad equity market and called for fresh all-time highs based on the results of our research.1 On May 1, 2019 we got confirmation as the SPX vaulted to new all-time highs, so that box is now checked. Chart 2The Yield Curve... Beyond the traditional yield curve inversion that forecasts that the Fed’s next move will be a cut and eventually the cycle ends, other yield curve type indicators have inverted and also foreshadow the end of the business cycle. Charts 3A & 3B show that the unemployment gap and another labor market yield curve type indicator have both inverted signaling that the business cycle is long in the tooth. Chart 3A...Is Always Right...Chart 3B...In Predicting Fed Cuts This time is no different and the business cycle will end. Why? Because the Fed has likely raised interest rates (as we first posited on November 19, 2018 and again on December 3, 2018) by enough to trigger a default cycle in the most indebted segment of the U.S. economy where the excesses are most prominent in the current expansion: the non-financial business sector (Chart 4A). Chart 4AMind The Corporate Debt Excesses Chart 4BDefault Cycle Looming Already, junk bond market spreads are widening and the yield curve is predicting that a default cycle is around the corner (yield curve shown on inverted scale, bottom panel, Chart 4B).  Another interesting indicator is the Presidential cycle. Chart 5 updates our work from last year showing years 2 & 3 of 17 Presidential cycles dating back to 1950. In the summer of year 3 the SPX typically peaks. Finally, the anecdote of the biggest unicorn, UBER, ipoing on May 10, 2019 also likely marks the ending of the cycle. Therefore if recession looms in the coming 18 months what is the typical magnitude of the SPX EPS drawdown and what multiple do investors pay for trough earnings? Chart 5Presidential Cycle Says Sell While the two most recent recessionary earnings contractions have been severe, we are conservative in estimating a garden variety recession causing a 20% EPS fall. S&P 500 2018 EPS ended near $162/share. This year $167/share is likely and we are now revising down our forecast for next year to $175/share from $181/share previously. A conservative 20% drawdown sets us back to $140/share in 2021. Dating back to the late 1970s when our IBES dataset on the forward P/E multiple commences, the trough forward P/E multiple during recessions averages out to 10x (Chart 6). Remaining on a conservative path we will use 13.5x, or the recent December 2018 trough multiple as our worst case multiple and a sideways move to 16.5x as the most optimistic case. This implies an SPX ending value of between 1890 and 2310 will be reached some time in 2020, with the former resetting the equity market back near the 2016 BREXIT lows. Chart 6Trough Recession Multiple Averages 10x As a result, we are not willing to play a 100-200 point advance for a potential 1000 point drawdown, the risk/reward tradeoff is to the downside. Can and has the Fed previously engineered soft landings that have caused big relief rallies in the equity market? Six times since the 1960s: once in each of the mid-1960s, early-1970s, mid-1970s, mid-1980s and mid-1990s and once in 1998 (top panel, Chart 7). Chart 7Six Mid-cycle Easing Attempts Three easing cycles were not forecast by a yield curve inversion, but the mid-1960s, the mid-1990s and in 1998 the yield curve cautioned investors that an easing cycle was looming (bottom panel, Chart 7). Specifically in 1998 the Fed only acted after the equity market fell by 20%. Another interesting observation is that ex-post five of these six iterations were truly mid cycle, one was very late cycle, but none took place in year 11 of an expansion as is currently the case. We are in uncharted territory. Chart 8 shows the mean profile of the S&P 500 six months prior to and one year post the initial Fed cut. Our assumption is that a cut in July may materialize, thus the vertical line in Chart 8 denotes t=0, which is in sync with the bond market that is pricing a greater than 75% chance of this occurrence. The subsequent market rallies were significant. Our insight from this research is that we already had the explosive rally as Chart 8 depicts, owing to the Fed’s completed pivot, with the stock market rallying from the 2018 Christmas Eve lows to the May 1, 2019 all-time highs by 26%. But, the jury is still out. The biggest risk to our call is indeed a continued rally in the S&P 500 on easy money. A way to mitigate this risk of missing out on a rally is by going long SPX LEAPS Calls once a greater than 10% correction takes root. Chart 8Is The Rally Already Behind Us? Keep in mind, that for the Fed to act and cut rates, stocks will likely have to breach the 2650 level, a point where a reflexive fall will further shake investor’s confidence in profit growth. In other words, the bond market is screaming that Fed cuts are looming, but it also means that stocks have ample room to fall before the Fed cuts rates, i.e. a riot point will force the Fed’s hand. Another big risk to this call is a swift positive resolution on the U.S./China trade dispute, and/or an unprecedented easing from the Chinese authorities which will put us offside as a euphoric rise will definitely ensue. Again SPX LEAPS Calls are an excellent way to position for such an outcome. Netting it all out, the risk/reward tradeoff remains squarely to the downside and we are turning cyclically (3-12 month horizon) cautious on the prospects of the broad equity market. The Presidential cycle, UBER’s IPO, the SPX hitting all-time highs following the initial December 2018 yield curve inversion, and two additional yield curve inversions signal that this time is no different and a recession is likely upon us in the coming 18 months. Thus, this week we are further de-risking the portfolio by downgrading a tech subindex to neutral, setting a tighter stop on a different long term tech subsector holding that has been the cornerstone of the equity bull market, and putting the overall tech sector on downgrade watch. Downgrade Tech Hardware Storage & Peripherals To Neutral In the context of further de-risking the portfolio we are downgrading the S&P tech hardware storage & peripherals index to a benchmark allocation and booking a small loss of 1.0% in relative terms since inception. Four reasons underpin our downgrade of this index that comprises almost 1/5 of the S&P tech market cap. First, index heavyweight Apple has 20% foreign sales exposure to the Greater China region. While we doubt the Chinese will directly retaliate to the U.S. restriction on Huawei by directly targeting Apple, it is still a risk. Moreover, recent news of the FTC and the DOJ targeting GOOGL and FB pose a risk to Apple, especially given its App Store dominance. Any negative news on either front would take a bite out of the sector’s profits. Second, capex has taken a bit hit. Chart 9 shows industry investment is almost nil and capex intentions from regional Fed surveys and from CEO confidence surveys signal more pain down the line. Third, the S&P THS&P index’s internationally sourced revenues are near the 60% mark, and computer exports are also flirting with the zero line. Worryingly, deflating EM Asian currencies are sapping consumer purchasing power and are weighing on industry exports (third panel, Chart 10). Chart 9Capex Blues Chart 10Exports... Similarly, global trade volumes have sunk into contractionary territory and to a level last seen during the Great Recession (not shown). With regard to export expectations the recently updated IFO World Economic Survey still points toward sustained global export ails (second panel, Chart 10). More specifically, tech laden Korean and Taiwanese exports are outright contracting at an accelerating pace and so are Chinese exports. Tack on the negative signal from the respective EM Asian stock market indices and the implication is that more profit pain looms for the S&P THS&P index (Chart 11). Finally, on the domestic front, new orders-to-inventories (NOI) have not only ground to a halt from the overall manufacturing sector, but also computer and electronic product NOI are not contracting on a short-term rate of change basis (bottom panel, Chart 10). Tracking domestic consumer outlays on computer and peripheral equipment reveals that they too have steeply decelerated from the cyclical peak reached in early 2018, painting a softening picture for industry sales growth prospects (Chart 12). Chart 11...Under Pressure Chart 12Soft Sales Backdrop  The re-escalation of the U.S./China trade tussle along with the risk of an antitrust investigation into Apple, waning capital outlays, softening exports and deteriorating operating conditions warn that it does not pay to be overweight the S&P THS&P index. Nevertheless, before getting too bearish there is a silver lining. This index has a net debt/EBITDA of 0.5x versus the non-financial broad market of 2x. On the valuation front this tech subindex trades at 28% discount to the non-financial broad market on an EV/EBITDA basis suggesting that most of bad news is already reflected in bombed out valuations (Chart 13). The re-escalation of the U.S./China trade tussle along with the risk of an antitrust investigation into Apple, waning capital outlays, softening exports and deteriorating operating conditions warn that it does not pay to be overweight the S&P THS&P index. Bottom Line: Downgrade the S&P THS&P index to neutral for a modest relative loss of 1.0% since inception. The ticker symbols for the stocks in this index are: BLBG: S5CMPE – AAPL, HPQ, HPE, NTAP, STX, WDC, XRX. Chart 13But B/S Remains Pristine Put Tech On Downgrade Alert We are compelled to put the S&P tech sector on our downgrade watch list as President Trump’s hawkish trade talk and actions since May 5 warn that tech revenues (60% export exposure) and profits will likely remain under intense downward pressure. The way we will execute this tech sector downgrade to underweight will be via the S&P software index, the sector’s largest market cap weight. A downgrade to neutral in the S&P software index would push our S&P tech sector weight to a below benchmark allocation. Thus, we are initiating a stop near the 10% relative return mark on the S&P software high-conviction overweight call since the December 3, 2018 inception and also lift the stop to 27% from 17% relative return on the cyclical overweight we have on the S&P software index since the November 27, 2017 inception. Any near term stock market pullback will likely trigger these stops and push the tech sector to an underweight position. Stay tuned. With regard to the overall tech sector, our EPS model is on the verge of contraction on the back of sinking capex and a firming U.S. dollar (middle panel, Chart 14). In more detail, tech capex has recaptured market share swinging from below 6% to above 13% in the past decade and now has likely hit a wall similar to the late 1990s peak (second panel, Chart 15). On a rate of change basis tech capital outlays have all peaked and national data corroborate the message from stock market reported data (bottom panel, Chart 15). Chart 14Grim EPS Model Signal Chart 15Exhausted Capex? The San Francisco Fed’s Tech Pulse Index (comprising coincident indicators of activity in the U.S. information technology sector) is also closing in on the expansion/contraction line warning that tech stocks are in for a rough ride (bottom panel, Chart 14). Delving deeper into operating metrics, we encounter some profit margin trouble for tech stocks. Not only do industry selling prices continue to deflate, but also our tech sector wage bill gauge is picking up steam. Taken together, all-time high profit margins – double the broad market – appear unsustainable and something has to give (Chart 16). On the export relief valve front, the sector faces twin headwinds. First the trade war re-escalation suggests that an interruption/disruption of tech supply chains is a rising risk, and the firming greenback will continue to weigh on P&Ls as negative translation effects will hit Q2, Q3 and likely Q4 profits (Chart 17). Chart 16Margin Trouble Chart 17Rising Dollar Will Weigh On Revenues & Profits Netting it all out, our tech EPS model is flashing red on the back of sinking capex and an appreciating U.S. dollar, deteriorating operating metrics signal that tech margins are under attack and exports are also in a freefall, suggesting that the time is ripe to put the tech sector on downgrade alert. Nevertheless, there are two sizable offsets contrasting all the grim news. Tech stocks are effectively debt free with the net debt/EBITDA sitting on the zero line and valuations a far cry from the tech bubble era. Finally, the drop in interest rates via the 10-year yield and looming Fed cuts will underpin these growth stocks that thrive in a disinflationary backdrop (Chart 18). Netting it all out, our tech EPS model is flashing red on the back of sinking capex and an appreciating U.S. dollar, deteriorating operating metrics signal that tech margins are under attack and exports are also in a freefall, suggesting that the time is ripe to put the tech sector on downgrade alert. Bottom Line: We are compelled to put the tech sector on our downgrade watch list. We will execute the S&P tech sector downgrade to underweight when the S&P software index’s stops are triggered. This would push the S&P software index to neutral from currently overweight. Stay tuned. Chart 18But There Is An Offset: Melting Yields Help Growth Stocks   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise” dated December 17, 2018, available at uses.bcaresearch.com.   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Maintain a pro-cyclical stance for the time being – overweight equities versus bonds, long commodities, overweight industrial equities, and underweight healthcare equities. But be warned, absent a continued decline in the bond yield and/or oil price, short-term positive impulses on the economy will fade and even turn negative later in the year. Hence in the summer months, look for opportunities to take profits in these pro-cyclical positions. U.K. economy plays can outperform once a cross-party parliamentary majority is found for a course of action that leads to an orderly Brexit (or no Brexit). Feature At the end of last year, we made a bold prediction: economies and financial markets would follow the opposite path in 2019 compared to 2018. Specifically we pointed out that “through most of 2018, global growth was decelerating while inflation was accelerating. Now this configuration is flipping: global growth is rebounding while inflation is set to collapse… 2019 will present investors a mirror-image pattern to 2018” (Chart of the Week). Chart of the WeekWhy 2019 Is The Opposite Of 2018 Four months on, we are delighted to report that the mirror-image pattern is unfolding exactly as predicted. This year, stock markets are up sharply; bond markets have rallied; metal prices have made double-digit gains, growth-sensitive industrial shares are outperforming; while defensive healthcare shares are underperforming. All of these are the precise opposite of what happened in early 2018 (Chart 1-2 - Chart I-6). Chart I-2Equities: 2019 Is The Opposite Of 2018 Chart I-3Bonds: 2019 Is The Opposite Of 2018   Chart I-4Commodities: 2019 Is The Opposite Of 2018 Chart I-5Cyclicals: 2019 Is The Opposite Of 2018   Chart I-6Defensives: 2019 Is The Opposite Of 2018 Why 2019 Is The Opposite Of 2018 The basis for our bold prediction was twofold. We noted that China’s 6-month credit impulse “had gone vertical” (Chart I-7). Indeed, the rebound from the trough amounted to $500 billion (and still counting), equivalent to a near 1 percent shot in the arm for global GDP. Chart I-7China's 6-Month Credit Impulse Has Gone Vertical We also argued back then that “a racing certainty for early 2019 is that headline inflation will collapse. This is because the plunge in the crude oil price is about to feed through into headline consumer price indexes. Inevitably, it will seep through into core inflation too, via the impact on energy dependent prices such as transport costs.” “Coming at a time that central banks have professed a much greater reliance on incoming data, we can deduce that central banks will find it hard to tighten policy in the face of weaker headline and core inflation prints. Crucially though, the ECB and BoJ were not planning on tightening policy anyway, so the plunge in reported inflation will be much more impactful on the Federal Reserve.” Lo and behold. China’s PMI has rebounded sharply, and the Fed has stopped hiking rates. Still, central banks’ enhanced ‘data-dependency’ carries perils. The high-profile hard data – such as CPI inflation and GDP growth prints – on which monetary policy ‘depends’ is a record of what happened in the past, sometimes the distant past. This year’s market moves are the precise opposite of what happened in early 2018. Hence, enhanced data-dependency means that central banks are now ‘driving by looking through the rear-view mirror’ rather than looking at the current terrain. In turn, monetary policy expectations are driving bond and equity market valuations. By contrast, equity market growth expectations are based on the here and now; they move in synch with economic activity in real-time, leading even the survey-based PMIs. This also solves the puzzle as to why bonds and equities can sometimes give conflicting messages. Last year, the configuration of accelerating inflation with decelerating global growth hit equities and with a lose-lose: heavy pressure on both valuations and growth expectations. Furthermore, when interest rates rise from low levels they undermine the support for elevated risk-asset valuations in a viciously non-linear way. Chart I-8In 2018, Higher Bond Yields Pressured Equity Valuations At low interest rates, bond prices develop the same unattractive negative asymmetry as equities. Therefore, an extended period of ultra-low interest rates removes the need for an equity risk premium, and justifies sharply higher valuations for equities and other risk-assets. But in early 2018, as hawkish central banks pushed up 10-year global bond yield towards 2 percent, this process reversed viciously: bond prices lost their negative asymmetry, re-requiring an equity risk premium and sharply lower valuations for risk-assets at a time that growth expectations were also sliding (Chart I-8).1 By contrast, the early 2019 configuration of dovish central banks and accelerating short-term credit impulses has provided equities a ‘mirror-image’ win-win: a boost to both valuations and to growth expectations.  What Happens Next In 2019? Chart I-9Headline Inflation Will Soon Tick Up Understand that the all-important impulses to an economy do not come from the level of the bond yield, oil price, net exports, inventories, and so on. The impulse always comes from the change in these metrics. And as the metrics cannot decline (or rise) incessantly, impulses always fade and then reverse. The oil price has rebounded 30 percent from its recent lows. Necessarily, this means that headline inflation prints will soon stabilise or even tick up (Chart I-9). Furthermore, central banks’ abrupt pivot to dovish has already happened. It would be hard to repeat or continue such a move. As central banks react to the inevitably backward-looking hard data prints, our expectation is that bond yields will stabilise or even tick up. Will equity markets also react positively to the better economic data prints? Not necessarily. To repeat, equity markets’ growth expectations move in synch with economic activity in real-time, leading even the survey-based PMIs. Equity markets never wait for the backward-looking data prints. China plays are tracking its short-term credit impulse which has gone vertical (Chart I-10). Hence, in 2019 to date, U.K. mining stocks are already up 25 percent; the Shenzhen Composite is already up 40 percent! Chart I-10China Plays Have Already Surged Still, the current win-win configuration can continue for a little while longer, given that a typical upswing in short-term credit impulses lasts around eight months. But be warned, absent a continued decline in the bond yield and/or oil price, short-term impulses will fade and even turn negative later in the year. The early 2019 configuration of dovish central banks and accelerating short-term credit impulses has provided equities a win-win. Hence, maintain a pro-cyclical stance for the time being – overweight equities versus bonds, long commodities, overweight industrial equities, and underweight healthcare equities. But our strong advice is: in the summer months, look for opportunities to take profits in all of these positions. When Will Brexit’s Groundhog Day End? We really would prefer not to talk about Brexit. It is not just that every day is Groundhog Day, every day is a shambolic Groundhog Day. Still, on a positive note this means that our investment strategy for Brexit has also remained a constant (Chart I-11). Chart I-11For Investors, Brexit Simplifies To A Binary Outcome It is not sufficient for the U.K. parliament to express what it is against (a no-deal Brexit); parliament must express what course of action it is for, leading to an orderly Brexit, or no Brexit, and that this course of action must also be acceptable to the EU27. At that point, irrespective of the exact course of action – a customs union, Common Market 2.0, or a confirmatory referendum in which ‘remain’ is an option – buy the pound, the FTSE250, and U.K. homebuilder shares. Theresa May’s overture to engage in a national unity strategy with the Labour Party is a step in the right direction. In this regard, Theresa May’s overture to engage in a national unity strategy with the Labour Party is a step in the right direction, because it finally puts national interest above party interest. To be clear, Brexit has been trapped in Groundhog Day because there is insufficient support among Conservative and DUP MPs for a relationship with the EU27 that would: Protect the cross-border supply chains which are vital to so many U.K. businesses. Avoid a hard customs border on the island of Ireland or between Ireland and Britain. Deliver on the narrow 52:48 vote to leave the EU, which was driven by a desire to control migration and the supremacy of the European Court of Justice; rather than a desire to strike independent trade deals, which is irrelevant for a majority of voters. The ray of light is that there is potentially a broader cross-party parliamentary majority for a course of action that would meet the above three conditions. Once it is found, U.K. economy plays can look forward to the “sunlit uplands”. Fractal Trading System* In line with the main body of this report, we continue to see evidence that the recent rally in bonds is technically extended. Accordingly, this week’s recommended trade is to short the 10-year OAT. The profit target is 1.3 percent with a symmetrical stop-loss. In other trades, short INR/PKR hit its 3 percent stop-loss and is now closed, leaving five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions.   *  For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance”, October 25, 2018 available at eis.bcaresearch.com  Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights Odds are that the recent improvement in Chinese manufacturing PMIs could be due to inventory re-stocking rather than a decisive turnaround in final demand. “Hard” data have not shown meaningful improvements in China’s final demand. Weighing the pros and cons, we are instituting a stop-buy on our EM strategy: We will turn tactically positive on EM risk assets if the MSCI EM equity index breaks above 1125, which is 4% above its current level. Keep Malaysia on an upgrade watch list. Downgrade Brazil to underweight. Feature The strong Chinese PMI prints released this week have challenged our negative view on EM assets and China plays. This week we take a deeper look at the underlying reasons behind the recent improvement in China’s PMI data. In addition, we elaborate on what it would take for us to alter our current strategy on EM risk assets. A Manufacturing Upturn The upturn in China’s manufacturing PMIs in March has been validated by improvement in Taiwanese PMI’s export orders (Chart I-1, top panel). The latter’s amelioration has been broad-based across all sectors: electronics and optical, electrical machinery and equipment, basic materials, and chemical/biological/medical (Chart I-1, bottom panel). China accounts for 30% of Taiwanese exports, making Taiwan’s manufacturing sector heavily exposed to China’s business cycle. Does this improvement in manufacturing PMIs reflect a final demand revival in China? Looking For Final Demand Revival China’s domestic and overseas orders remain weak, as exhibited in Chart I-2. These indicators give us the primary trajectory of the Chinese business cycle, while the PMI indexes exhibit considerable short-term volatility. Chart I-1One-Month Surge In China's And Taiwan's PMIs Chart I-2Noise And Business Cycle Trajectory   The domestic demand and overseas orders reflect quarterly data from 5,000 enterprises. The latest datapoints are from Q1 2019 and were released on March 22. To be sure, we are not suggesting an absence of bright spots, but at the moment “hard” data do not corroborate broad-based improvement in final demand. Consumer spending: There has been no improvement in households’ propensity to spend. Our proxy for households’ marginal propensity to spend has not turned up (Chart I-3). Consistently, China’s smartphone sales and passenger car sales are contracting at double-digit rates, while the growth rate in online sales of services has not improved (Chart I-4, top three panels). Chart I-3Chinese Consumers' Propensity To Spend Chart I-4China: No Improvement In "Hard" Data   The bottom panel of Chart I-4 demonstrates the retail sales of consumer goods during the Chinese New Year compared with the previous year’s spring festival. It is evident that as of mid-February, when this year’s spring festival took place, there was no improvement in Chinese consumer demand. Business spending / investment: Our proxy for enterprises’ propensity to spend continues to decline (Chart I-5). Companies’ propensity to spend has historically led the cyclical trajectory in industrial metals prices. Crucially, this has not corroborated the rebound in base metals prices over the past three months. Besides, China’s imports of capital goods, its total imports from Korea and its machinery and machine tool imports from Japan are all still contracting at a double-digit rate (Chart I-6). Chart I-5China: Enterprises' Propensity To Spend And Metals Chart I-6Contracting At A Double Digit Rate   China’s fixed asset investment in infrastructure has picked up of late and will continue to improve. However, this may not be sufficient to revive the mainland’s economy. China’s growth decelerated in 2014-2015 and industrial commodities prices dwindled, despite robust growth in infrastructure investment at the time (Chart I-7). The culprit was the decline in property construction in 2014-2015. As to the property market, the People’s Bank of China’s (PBoC) Pledged Supplementary Lending (PSL) financing points to further weakness in property demand in the coming months (Chart I-8). Chart I-7China's Infrastructure Investment And Base Metals Prices Chart I-8China: The Outlook For Residential Property Demand   Moreover, property starts have been surging, yet their completions have been tumbling. This suggests a ballooning amount of work-in-progress on real estate developers’ balance sheets. To be sure, we are not suggesting an absence of bright spots, but at the moment “hard” data do not corroborate broad-based improvement in final demand. It may well be that property developers do not have financing to complete work or that they are reluctant to bring new units to the market amid tame demand. Whatever the case, the mediocre pace of construction activity is negative for suppliers to the construction industry. Government spending: Aggregate government spending in China – including central and local government as well as government-managed funds (GMF) – has been very robust in the past year (Chart I-9). Hence, government spending has not been the reason behind the economic slowdown. Chart I-9China's Aggregate Fiscal Spending For 2019, overall government spending is projected to expand by 11% in nominal terms from a year ago, down from 17% in 2018. The key fiscal risk is shrinking land sales, which account for 86% of GMF revenues. The latter have substantially increased in size and now makeup 27% of aggregate fiscal spending. Local and central government expenditures account for 62% and 11% of aggregate fiscal spending, respectively. If land revenues undershoot, GMF and local governments will not be able to meet their expenditure targets without Beijing altering the former’s borrowing quotas. In brief, fiscal policy may be involuntarily tightened due to a shortfall in land sales revenues before the central government permits local governments to borrow more. Exports: Chinese shipments to the U.S. will recover as China and the U.S. finalize their trade deal. The media is extremely focused on the trade negotiations, and markets have been trading off the headlines. Nevertheless, it is essential to realize that China’s exports to the U.S. make up only 3.6% of the country’s total GDP (Chart I-10). This contrasts with capital spending that accounts for 42% of the mainland’s GDP.  Consequently, we believe the credit cycle that drives construction and capital spending is more important to China’s growth than its shipments to the U.S. Global ex-China Demand: The areas of global final demand that weighed on global growth last year remain depressed. Global semiconductors and auto sales have been shrinking at a rapid pace and have so far not experienced a reversal (Chart I-11). Chart I-10China Is Not Reliant On Exports To The U.S. Chart I-11Global "Hard" Data Are Still Bad   Bottom Line: There is a lack of pertinent “hard” business cycle data in China that have improved. What Does It All Mean Having reviewed final demand conditions in China, it is reasonable to argue that the improvement in the Chinese and Taiwanese manufacturing PMIs could be due to inventory re-stocking. Unfortunately, in China, there is limited reliable data that quantifies inventory levels well in various industries. Having reviewed final demand conditions in China, it is reasonable to argue that the improvement in the Chinese and Taiwanese manufacturing PMIs could be due to inventory re-stocking. The consensus view in the investment community is that China’s credit stimulus has boosted the economy since the beginning of this year. Business conditions have certainly improved. The rally in Chinese stocks has in turn mirrored this improvement. Yet it is not clear that this revival in the business cycle is due to the credit stimulus. Chart I-12 plots the credit impulse, including local government general and special bonds issuance, with the three typical business cycle variables: manufacturing PMI and nominal manufacturing production growth. Chart I-12China: Credit Impulse Leads "Hard" Data As can be seen from the chart, the manufacturing PMI is very volatile. In the short term, there is little correlation between it and the credit impulse (Chart I-12, top panel). Meanwhile, the credit impulse leads nominal manufacturing output growth by nine months (Chart I-12, bottom panel). Based on the past time lag relationships, the mainland’s business cycle should not have bottomed until the third quarter of this year. Hence, the bottom in the manufacturing PMIs in January does not fit the historical pattern of the relationship between the credit impulse and the mainland’s business cycle. Bottom Line: Presently, it is hard to make a definite conclusion on the reasons behind the pick-up in Chinese manufacturing. That said, business cycles do not always evolve in a common-sense manner that can be both rationalized and forecast by indicators. Therefore, it is essential for investors, to have confirmation signals from financial markets on the direction of the business cycle. Financial Markets As A Litmus Test We continuously monitor numerous financial markets that are sensitive to both the global and Chinese business cycles. These financial market-based indicators are often coincident with EM asset prices. Hence, they can be used to confirm or refute EM market direction. Our Risk-On-to-Safe-Haven (ROSH) currency ratio has recently softened, flashing a warning signal for EM share prices (Chart I-13). Chart I-13Currency Markets Are Flashing Amber For EM Stocks The ROSH ratio is the relative total return (including carry) of six commodities currencies (AUD, NZD, CAD, CLP, BRL and ZAR) versus two safe-haven currencies: the yen and Swiss franc. Hence, this currency ratio is agnostic to U.S. dollar trends, making its signals especially valuable. Our Reflation Confirming Indicator has retreated, also signaling a pullback in the EM equity index (Chart I-14). This indicator is composed of an equal-weighted average of industrial metals prices (a play on Chinese growth), platinum prices (a play on global reflation) and U.S. lumber prices (a proxy play on U.S. growth). Chart I-14Commodities Markets Are Flashing Amber For EM Stocks Within EM credit markets, corporate investment-grade spreads have begun narrowing versus high-yield spreads (Chart I-15). This typically coincides with lower EM share prices. Finally, EM share prices have been underperforming DM since late December. Relative performance of EM ex-China stocks against the global equity index has been even more underwhelming. In short, these markets are at a critical juncture. A decisive breakout will entail a lasting rally, while a failure to break out will signal imminent downside risk. Bottom Line: These financial market signals are not consistent with a durable China-led recovery in the global business cycle. Investment Strategy A number of financial markets are currently at a critical juncture. These markets will either break out or break down, with subsequently significant moves. The broad U.S. trade-weighted dollar has been flattish in the past nine months despite falling interest rate expectations in the U.S. and the risk-on market environment. We read this as a sign of underlying strength. The trade-weighted dollar is presently sitting on its 200-day moving average (Chart I-16). Consistent with a flattish trend in the greenback, the U.S. dollar volatility has dropped to very low levels. Exchange rates usually do not trade sideways much longer than that. Hence, the dollar is about to break out or break down and any move will be lasting and large. Chart I-15A Message From EM Corporate Credit Market Chart I-16The U.S. Dollar Is About To Make A Big Move   The Korean won has been forming a tapering wedge pattern from both short-term and long-term perspectives (Chart I-17, top and middle panels). Its volatility has also plunged to a record low (Chart I-17, bottom panel). Chart I-17The Korean Won Is At Crossroads Chart I-18A Stop-Buy On EM Stocks Finally, emerging Asian equities’ relative performance to global stocks is facing an important technical resistance as are copper and oil prices. In short, these markets are at a critical juncture. A decisive breakout will entail a lasting rally, while a failure to break out will signal imminent downside risk. Consistently, China’s “soft” data that has improved markedly yet there is no “hard” data confirmation. Moreover, there is some evidence to suggest that the pickup in the soft data may simply reflect inventory building.   Weighing the pros and cons, we are instituting a stop-buy on our EM strategy: We will turn tactically positive on EM risk assets if the MSCI EM equity index in U.S. dollar terms breaks above 1125, which is 4% above its current level (Chart I-18). Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Malaysia: Keep On Upgrade Watch List Malaysian equities have been underperforming their EM counterparts since 2013 and are now resting around their 2017 lows (Chart II-1). The odds are high that this market’s underperformance is late. Chart II-1Malaysian Stocks Relative to EM Investors should keep Malaysian equities on an upgrade watch list. We upgraded the Malaysian bourse from underweight to neutral in December 2018. In a Special Report published at that time, we argued that the structural outlook for Malaysia had improved, yet the cyclical downturn would persist. The latter did not warrant moving the bourse to overweight. This view is still at play. Economic Slowdown Is Advanced The Malaysian economy has been digesting credit and property market excesses. Property sector: Property sales have declined by 37% since 2010, and prices for some property segments are beginning to deflate (Chart II-2). Similarly, housing construction approvals have slumped severely since 2012. Consumers: Passenger vehicle sales have been falling since 2012 along with households' declining marginal propensity to consume, and retail trade has been very weak (Chart II-3). Chart II-2Property Sector Is Depressed Chart II-3Consumer Sector Is Weak   An ongoing purge of excesses by companies entails lower wage growth and weaker employment, resulting in subdued household income growth. The latter could extend the consumer slump. Business sector: Capital spending growth in real terms has decelerated and may contract. Both profit margins and return-on-equity (ROE) for non-financial publicly listed companies have slumped and are currently resting below their 2008 levels (Chart II-4). This warrants cost-cutting and reduced corporate spending/capital expenditures for now. Chart II-4Corporate Restructuring On The Way? Reduced employment and weak wage growth are negative dynamics for households but positive for companies’ profit margins. Commercial Banks: Malaysian banks remain unhealthy. At 1.5%, their NPLs remain low relative to the credit boom that occurred over the past decade. Moreover, Malaysian banks have been lowering their provisions levels to boost profits. This is an unsustainable strategy. Provided economic growth will remain weak, both NPLs and provisions will rise, hurting banks’ profits and share prices. Banks hold a very large market-cap weighting in this bourse, and the negative outlook for banks’ profits deters us from upgrading this equity market. Purging Excesses: Implications For The Exchange Rate Purging of economic excesses is painful in the short- and medium-term, as it instills deflation. A currency often depreciates during this phase to mitigate the deflationary forces in the economy. However, purging excesses, deleveraging and corporate restructuring are ultimately structurally bullish for a currency. First, corporate restructuring and improved capital allocation lift productivity growth in the long run. The Malaysian economy has been digesting credit and property market excesses. Second, low inflation or outright deflation allow the currency to depreciate in real terms. The Malaysian ringgit is already cheap based on the real effective exchange rate (Chart II-5). Finally, amid deflation and in the absence of widespread bailout of debtors funded by bank loans or excessive government borrowing, cash becomes “king”. Hence, deleveraging is ultimately currency positive. In contrast, pervasive bailouts funded by money creation – i.e., mushrooming money growth – usually undermine residents’ and foreigners’ willingness to hold the currency. A capital flight ensues and the currency plunges. Malaysia in 2015 was the latter case, with the ringgit plummeting as residents converted their ringgits to U.S. dollars (Chart II-6, top panel). Chart II-5The Ringgit Is Cheap Chart II-6Malaysia: 2015 Vs. Now   Presently, the opposite dynamics are at play. The central bank is reducing commercial banks’ excess reserves, domestic private credit growth is weak and residents are not fleeing the ringgit (Chart II-6). In addition, the structural reorientation of the economy from commodities to semiconductors/technology is beginning to bear fruit. As a result, overall trade balance has significantly improved, despite weak commodities prices. This is also positive for the currency. Finally, a more stable (i.e., modestly weaker) exchange rate amid both a global and domestic downturn will allow Malaysia’s central bank to reduce interest rates and smooth the growth slump. This is in contrast to 2015 when capital outflows and the plunging currency did not allow the central bank to reduce borrowing costs. Investment Conclusions We recommend keeping Malaysian stocks on an upgrade watch list for now. We recommend upgrading Malaysian sovereign credit and local currency government bonds from underweight to neutral relative to their respective EM benchmarks A relatively stable ringgit will benefit Malaysia’s local and U.S. dollar bonds. Furthermore, foreign ownership of local bonds has fallen meaningfully, diminishing the risk of future outflows. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Downgrading Brazil: The Honeymoon Is Over In our October 9 report, we upgraded Brazil following the outcome of the first round of presidential elections. We, like the market, gave a benefit of the doubt to the new president. However, the honeymoon is over for President Bolsonaro. The markets are becoming increasingly pessimistic because of the lack of progress on the social security reforms front. It is no secret that Brazil needs bold pension reform to make its public debt sustainable. As things stand now, the public debt dynamic in Brazil is precarious. Two prerequisites for public debt sustainability are (1) for interest rates to be below nominal GDP growth or (2) continuous robust primary fiscal surpluses. Hence, a government can stabilize its debt-to-GDP ratio by either having nominal GDP above its borrowing costs, or by running persistent and sizable primary fiscal surpluses. Neither of these two stipulations are presently satisfied in Brazil. The gap between government local currency bond yields and nominal GDP growth is still very wide (Chart III-1). Meanwhile, the primary fiscal deficit is 1.5% of GDP (Chart III-2). Chart III-1Brazil: An Unsustainable Gap Chart III-2Brazil: Public Debt Dynamics Are Precarious     In the early 2000s, the government stabilized its public debt dynamics by running persistent primary surpluses of about 4% of GDP (Chart III-2, top panel). Will Brazil achieve primary fiscal surpluses in the coming years assuming some form of the pension reform is adopted? It is doubtful. According to the government’s own forecasts, the submitted draft of social security reforms, including the one for the army, will save only BRL190 billion in next four years or 0.7% of GDP per year. The current primary deficit is 1.5% of GDP (Chart III-2). Unless nominal GDP growth and government revenue growth shoot up, the primary deficit will not be eliminated or the primary surplus will be very small. Overall, it seems unlikely that the government’s proposed pension reforms will be sufficient to turn around Brazil’s public debt dynamics in the next several years - barring very strong economic growth that will fill in government coffers. Bottom Line: We are downgrading Brazil from overweight to underweight within EM equity, local currency bonds and sovereign credit benchmarks. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The yield curve has inverted: The 10-year Treasury bond yield fell below the 3-month T-bill rate following the March FOMC meeting and has remained there since. We never say it’s different this time, but there is not yet sufficient evidence to change course: The yield curve is almost always early as a standalone signal, and the depressed term premium may make it less sensitive right now. Monetary policy still looks decidedly accommodative to us, … : Our estimate of the equilibrium fed funds rate says policy’s easy, and that it’ll stay that way until the Fed gets serious about hiking rates again. … so asset allocation should continue to favor risk assets: There are global forces restraining Treasury yields, but the fed funds rate cycle is only partway through a stretch that has been uniformly unfavorable for Treasuries. Feature Last week’s data were soft, as the U.S. economy continues to show signs of decelerating. The consumer confidence survey disappointed hopes for an extended bounce back from January’s shutdown-shadowed release, housing starts were uninspiring, and the Case-Shiller index revealed that home-price gains continue to sag. Beyond the U.S., the message from manufacturing PMIs is glum, although the services sector seems to be holding up just fine. Our traveling colleagues report that investors around the world have developed a decided aversion to European assets. We remind our clients that deceleration is nothing new. It’s been the story so far this year, as the incremental decline in fiscal thrust ensured it would be. The inversion of the yield curve is new, however, and it’s commanding attention from the financial media and from investors drawn to a leading indicator that consistently works. We like the yield curve, too, and it’s one of the three components of our recession indicator, but it’s only one. The other two components have yet to confirm its message, and the way things look now, it may well be awhile before they do. The Yield Curve Has Inverted, The Yield Curve Has Inverted The 3-month-to-10-year segment of the yield curve inverted after the March FOMC meeting, and it dipped a little further into negative territory last week as the 10-year Treasury yield continued to melt. An inverted curve is one of the three components of our simple recession indicator,1 and we believe it can send an important signal about the economy’s vigor and the state of monetary policy. By itself, however, an inverted curve is not a sufficient precondition for a recession. It has also been something less than a timely guide to asset allocation, inverting a year ahead of a recession, on average, and six months before the S&P 500 peaks (Table 1). The yield curve has been a reliable recession warning signal, but it tends to be too early to serve as a practical guide to money management and asset allocation. Table 1Inverted Yield Curves, 1968 - 2018   An inverted yield curve has called eight of the seven recessions that have occurred over the last 50 years, making it a dependable leading indicator (Chart 1). Year-over-year contraction in the Conference Board’s Leading Economic Index (LEI) has compiled the same enviable track record, calling all seven of the last half-century’s recessions with just one false positive (Chart 2). LEI tends to be timelier, however, sounding the alarm an average of five months after the curve inverts (Table 2). For our recession indicator, we also add a comparison of the fed funds rate to our estimate of the equilibrium fed funds rate, because recessions have only occurred when the fed funds rate has exceeded our estimate of the equilibrium rate (Chart 3). Chart 1The Yield Curve Has Been Reliable, Albeit Early Chart 2LEI Has Been Timelier Table 2LEI Contractions, 1968 - 2018   The cycle is extended, and the inverted curve has made us even more alert for trouble in the economy and financial markets, but we do not think trouble is imminent. The LEI is clearly decelerating, but it has yet to contract. We currently peg the equilibrium fed funds rate at about 3⅛%, and project that it will rise to 3⅜% by the end of the year. We can’t know the equilibrium rate with exact precision in real time, but our estimate has been a reliable guide to financial market performance, and the fact that the fed funds rate is four 25-basis-point hikes from crossing the line gives us some comfort that neither a recession nor a bear market is waiting just around the corner. Chart 3Recessions Only Occur When Policy Is Tight Bottom Line: We are not dismissing the inverted yield curve, but our other recession-indicator inputs are not confirming its warning. Given the Fed’s new guidance, we expect that the next recession will not arrive before mid-to-late 2020. It’s A Little Bit Anomalous This Time At its best, an inverted yield curve is a signal from the bond market that the Fed has tightened monetary policy too much, heralding future rate cuts and a sharp slowdown. Anything affecting yields at the long end, however, has the potential to skew the curve’s signal. If long yields were somehow inflated, the curve would be less prone to invert and the signal would be delayed. If long yields were restrained, the curve would be prone to invert sooner and the signal might come especially early. Rate hikes invert the curve once the bond market decides they’re unnecessary, or expects that they’re going to be reversed soon. We believe that the yield curve currently has a bias to invert even earlier than it otherwise would. The question of how much the Fed’s asset purchases have affected the term premium,2 if at all, is far from settled within either the Fed or BCA, and is beyond the scope of this report. Nonetheless, we do think that QE1, QE2, and QE3 must have made some contribution to the decline in the term premium on long-term bonds (Chart 4). The bottom line is that we think the curve was disposed to invert earlier this time around. Its signal is still worth incorporating into our analysis, but we will seek confirmation from our other recession indicators before revamping our asset-allocation recommendations in line with an approaching inflection point in the business cycle. Chart 4The Curve Inverts More Easily When The Term Premium Is Negative The Fed And The Yield Curve We subscribe to the idea that the Fed induces recessions by removing monetary accommodation in an attempt to keep the economy from overheating. It’s simply too difficult to achieve a soft landing with policy tools that influence activity indirectly and with long and variable lags, given that the dual-mandate metrics are themselves lagging indicators. Compared to the path by which the Fed influences the economy, the path by which it inverts the curve is simple and straightforward. It raises short rates, and the long end rises as well, as the bond market discounts higher inflation and/or stronger growth, until investors no longer believe that inflation or growth prospects merit tighter policy, and long rates fall behind short rates. We reviewed moves in 10-year yields and 3-month rates across the different phases of the fed funds rate cycle (Chart 5) to see how the process has unfolded empirically. As the mechanics of yield curve inversion imply – short rates rise, long rates rise less or fall – the curve bear flattens when the Fed hikes the fed funds rate, and bull steepens when it cuts it (Table 3). The outcome fits the intuition: if the Fed’s attempt to slow the economy with higher short rates is successful, real interest rates will decline, inflation pressure will ease and bond yields should fail to keep pace with bill rates, especially if investors associate tightening campaigns with recessions. Conversely, if the Fed successfully boosts the economy with lower short rates, bond yields should fall less than short rates as the real component of rates rises, and the curve should steepen. Table 3The Yield Curve And The Fed Funds Rate Cycle Depicting our stylized fed funds rate as a bell curve makes for an appealing picture, but it obscures the fact that the Fed often pauses for a while after hiking rates to their cyclical peak, or cutting them to their cyclical trough. Phase II doesn’t end until the beginning of the next rate-cutting campaign, and Phase IV doesn’t end until the beginning of the next series of rate hikes. A stricter representation of the fed funds rate cycle would have two phases of active hiking, followed by a state of limbo between the last hike and the first cut, then two phases of active cutting, followed by a lull during which the Fed waits for signs that it should remove accommodation. The expanded fed funds rate cycle is therefore composed of active hiking in Phase I and Phase II(a), pre-easing in Phase II(b), active easing in Phase III and Phase IV(a), and pre-hiking in Phase IV(b). Table 4 shows the average monthly changes in the yield curve and its components in the expanded fed funds rate cycle. There is quite a difference between Phase II(a), when the curve aggressively bear flattens, and Phase II(b), when the curve modestly bull flattens. Phase IV(a) features a sharp bull steepening, while the long end drifts higher in Phase IV(b) and short rates barely budge. Ultimately, the real action happens when the Fed is actively adjusting monetary policy, and the duration positioning implications are quite sensitive to the transitions into and out of the active phases. Table 4The Yield Curve And The Expanded Fed Funds Rate Cycle Bonds And The Fed Funds Rate Cycle An inverted yield curve has provided a reliable early-warning signal about recessions, but it can be too early to drive asset-allocation decisions for a manager judged on relative returns. The curve moves in Tables 3 and 4 offer more timely implications for duration positioning within fixed-income portfolios across the fed funds rate cycle. It comes as no surprise that Treasuries perform better when the Fed is cutting rates (Phases III and IV) than they do when the Fed is hiking them (Phases I and II). Their returns should be inversely correlated with the direction of rates, and longer-maturity instruments should exhibit greater sensitivity to changes in the fed funds rate (Table 5). Table 5Treasuries And The Fed Funds Rate Cycle Overweight duration within bond portfolios from when the Fed stops hiking rates until it stops cutting them; underweight duration when it’s actively hiking. Expanding the fed funds rate cycle to account for active hiking, active easing, and the pre-hiking/pre-cutting limbo periods makes the duration-positioning road map clearer. Treasuries lose ground in real terms when the Fed is actively hiking, with longer-maturity instruments bearing the brunt (Table 6). They deliver in a big way when the Fed is actively easing (Phase III and Phase IV(a)), with the Barclays Bloomberg Long Treasury Index posting double-digit annualized total returns. Longer Treasuries shoot out the lights once the Fed stops hiking (Phase II (b)), and they generate real total returns that compare favorably with bull-market equities when aggregating Phase II(b)’s pre-easing results with active-easing Phases III and IV(a). Table 6Treasuries And The Expanded Fed Funds Rate Cycle Our terminal and equilibrium fed funds rate estimates are admittedly far from the consensus. Markets are skeptical of the FOMC’s one-more-hike projection, much less our three, four, or more terminal-rate call. With “secular stagnation” searches ascendant on Google Trends (as of Friday morning, the partially complete March 24-30 period already had the most searches of any week over the last twelve months), our equilibrium estimate is also surely out of step with the herd. If the Fed is not done, however, history says it’s not yet time to overweight duration. If we’re right, Treasuries still have the full Phase II(a) ahead of them, and won’t be a buy until the Fed desists, sometime in 2020 or beyond. Investment Implications We have taken note of the inverted yield curve, but we will not overreact to it. While it has been a reliable recession indicator for the last half-century, it consistently sounds the alarm too early to merit immediate investment action. Neither the LEI nor our equilibrium fed funds rate model has yet corroborated its warning, and the bombed-out term premium may have biased it to inverting even sooner than it otherwise would. There’s no need for Paul Revere to ready his horse just yet. We did not anticipate that the 10-year Treasury yield would decline as much as it has. The extent of the Fed’s dovishness caught us off guard, and the 10-year Treasury is having a very hard time escaping the gravity of the decline in major-economy sovereign yields around the world. Our Global Fixed Income Strategy service (GFIS) points out that the global yield decline has become extended (Chart 6), and it contends that global bond prices incorporate too much pessimism about global economic momentum. The GFIS team also notes that there’s no guarantee stock prices will fall to align with bond yields – over the last couple years, stocks and bonds have recoupled following yield scares via bond, not equity, sell-offs (Chart 7). Chart 6Enough Is Enough Chart 7Equities Have Been Smarter Than Bonds The Last Few Years We therefore remain constructive on the economy and financial markets, and advise that balanced portfolios should still maintain exposure to riskier assets. Much of that view depends on Chinese authorities relaxing their deleveraging campaign, global trade tensions easing, and some hint of green shoots appearing in the rest of the world. If those elements of our base-case scenario fail to materialize, we will likely become more cautious. We are not happy that the vindication of our high-conviction view on the terminal fed funds rate has been indefinitely delayed, but the silver lining of the Fed’s dovish surprise is that the bull market in equities and other risk assets has been granted an open-ended extension.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Please see the U.S. Investment Strategy Special Report, “How Much Longer Can The Bull Market Last?,” published August 13, 2018. Available at usis.bcaresearch.com. 2 Long-term bond yields can be decomposed into the expected path of short-term rates and a term premium, which compensates an investor for the uncertainties that can arise over the extended time period that s/he is locking up his/her money by buying a longer-maturity instrument.